Herman N. and Veronica Welter - Page 5

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          within the meaning of 26 C.F.R. section 1.1221-2 (1996) (former             
          section 1.1221-2).  Respondent contends, among other things, that           
          Mr. Welter’s commodities trading activity is not described in               
          former section 1.1221-2.                                                    
               B.  Law                                                                
               The term “capital asset” includes all classes of property              
          not specifically excluded by section 1221.  Sec. 1.1221-1(a),               
          Income Tax Regs.  Section 1221, as in effect during the years at            
          issue, did not contain a specific exclusion relating to hedging             
          transactions.  However, former section 1.1221-2(a)(1) provided              
          that, notwithstanding section 1.1221-1(a), Income Tax Regs., the            
          term “capital asset” does not include property that is part of a            
          hedging transaction.2  Former section 1.1221-2(b) defined the               
          term “hedging transaction” as follows:3                                     
                    (b) Hedging transaction defined.  A hedging                       
               transaction is a transaction that a taxpayer enters                    
               into in the normal course of the taxpayer’s trade or                   
               business primarily –                                                   
                         (1) To reduce risk of price changes or                       
                    currency fluctuations with respect to ordinary                    

               2  That regulatory exclusion was codified in 1999.  See sec.           
          1221(a)(7) and (b)(2), added by the Ticket to Work and Work                 
          Incentives Improvement Act of 1999, Pub. L. 106-170, sec.                   
          532(a)(3), 113 Stat. 1928.                                                  
               3  Former sec. 1.1221-2(g)(2)(i) provided that, in the case            
          of transactions entered into prior to Oct. 1, 1994, taxpayers               
          could rely on the rules of sec. 1.1221-2T, Temporary Income Tax             
          Regs., 58 Fed. Reg. 54037 (Oct. 20, 1993) (former sec. 1.1221-              
          2T).  The definitions of “hedging transaction” in former sec.               
          1.1221-2(b) and former sec. 1.1221-2T(b)(1), respectively, are              
          substantially identical.                                                    

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