T.C. Memo. 2003-81



                UNITED STATES TAX COURT



     PETER U. AND MARY M. BOEHME, Petitioners v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 6668-00.              Filed March 20, 2003.



     M (who together with her husband, P, filed joint
returns for the audit years) assigned her right to
receive certain future annual lottery payments in
exchange for a lump-sum payment to her by W of
$400,000. M used $250,000 of the $400,000 to repay
loans to M, which had been secured by the future annual
lottery payments. Of the $250,000, $186,000
represented repayment of the outstanding principal
amount of the loans and the $64,000 balance qualified
as the payment of interest.

     1. Held: M’s right to receive certain future
annual lottery payments does not constitute a capital
asset. Davis v. Commissioner, 

 (2002)
followed.

     2. Held, further, the $400,000 that M received
from W is ordinary income.
                               - 2 -

          3. Held, further, the $64,000 interest payment
     constituted the payment of nondeductible “personal
     interest” under sec. 163(h), I.R.C.



     Peter U. Boehme and Mary M. Boehme, pro sese.

     Ronald T. Jordan, for respondent.



                        MEMORANDUM OPINION


     HALPERN, Judge:   By notice of deficiency dated March 31,

2000, respondent determined deficiencies in petitioners’ Federal

income tax for 1995 and 1996 (the audit years) in the amounts of

$2,985 and $140,857, respectively.     After concessions, the issues

remaining for decision are (1) whether $400,000 received by

petitioner Mary M. Boehme in 1996 in exchange for her right to

receive certain future annual lottery payments is ordinary income

or capital gain, and (2) whether petitioners are entitled to

deduct, for 1996, $64,000 paid by Mary in connection with the

repayment of loans to her secured by her lottery winnings.

Petitioners raised the latter issue during a hearing in lieu of

trial (the hearing) without objection by respondent.1

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years at issue, and


     1
        Certain adjustments to petitioners’ dependency
exemptions and schedule A itemized deductions for 1996 are
derivative of the adjustments at issue and will be resolved by
our resolution of those adjustments.
                              - 3 -

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                           Background

     This case was submitted fully stipulated under Rule 122.

The facts stipulated by the parties are so found.    The

stipulation of facts (including facts stipulated at the hearing),

with accompanying exhibits, are incorporated herein by this

reference.

     Hereinafter, petitioners (husband and wife) will be referred

to individually as Peter and Mary.    At the time the petition was

filed, petitioners resided in Mooresville, Indiana.

     The following is a summary of the facts necessary for our

discussion.

     In 1991, while petitioners were residing in Colorado, Mary

won $1.5 million from the Colorado State Lottery, which was to be

paid over a 25-year period in annual payments commencing October

10, 1991, and ending October 10, 2015.   In order to make the 25

lottery payments, the Colorado State Lottery purchased an annuity

and named Mary as the beneficiary.

     On July 19, 1995, September 30, 1995, November 3, 1995, and

March 7, 1996, Mary received four separate loans (the loans) from

Metwest Services of Spokane, Washington (Metwest).    As collateral

for the loans, Mary pledged 12 future lottery payments (the 12

future lottery payments), which were due to be paid to her on
                               - 4 -

October 10, 1996, through October 10, 2007, in the following

amounts, before applicable tax withholdings:

               Payment Date            Gross Amount
               Oct. 10, 1996             $44,968
               Oct. 10, 1997              46,631
               Oct. 10, 1998              48,356
               Oct. 10, 1999              50,145
               Oct. 10, 2000              52,000
               Oct. 10, 2001              53,924
               Oct. 10, 2002              55,919
               Oct. 10, 2003              57,988
               Oct. 10, 2004              60,133
               Oct. 10, 2005              62,357
               Oct. 10, 2006              64,664
               Oct. 10, 2007              67,056
                    Total                664,141

     On April 30, 1996, Mary and Woodbridge Financial Corp.

(Woodbridge) executed a “Lottery Prize Assignment Agreement” (the

assignment agreement) pursuant to which Mary assigned to

Woodbridge her rights to receive the 12 future lottery payments,

before applicable tax withholdings, in exchange for a lump-sum

payment of $400,000 payable within 5 days after the Colorado

State Lottery and the annuity company funding the lottery

payments had given their approval of the assignment.

     On May 6, 1996, Mary and Woodbridge executed an addendum to

the assignment agreement (the addendum) pursuant to which the

parties agreed that Mary would use up to $250,000 of the $400,000

to be received pursuant to the assignment agreement to repay the

balance due on the loans (anticipated not to exceed $250,000 by

Mary and Woodbridge), and that Woodbridge would pay directly to

Mary any outstanding balance in excess of $250,000.    The parties
                               - 5 -

intended that Mary retain at least $150,000 after repayment of

the outstanding balance of the loans.   In August 1996, $250,000

was paid in satisfaction of the balance due on the loans, and

$150,000 was received and retained by Mary.

     On Schedule D, Capital Gains and Losses, of their 1996

return, petitioners reported a $264,000 long-term capital loss

arising out of the foregoing transactions.    That loss was derived

by treating $400,000 as the sales price or amount realized by

virtue of Mary’s assignment of the 12 future lottery payments to

Woodbridge and treating the gross amount of the assigned payments

($664,000) as Mary’s basis in such payments.   Petitioners then

claimed a capital loss deduction of $3,000 in computing their

total income for 1996.   Respondent’s notice of deficiency issued

on March 31, 2000, disallowed the $3,000 deduction and determined

that the transaction with Woodbridge resulted in $400,000 of

ordinary income to petitioners.   During the hearing, petitioners

conceded that the entire $400,000 is includable in income, but

they maintain that it should be treated as capital gain.2


     2
        Although the matter is not specifically addressed by the
parties, they appear to agree that the issue is whether to
characterize the $400,000 as ordinary income or as long-term
capital gain. Petitioners originally reported the transaction as
generating long-term capital loss, and respondent has not raised
an issue as to petitioners’ holding period for the assigned right
to the 12 future lottery payments. We, therefore, assume that
respondent agrees that such right, which arose in 1991, had been
held for more than 1 year at the time of its sale to Woodbridge
in 1996; and that, assuming such right constitutes a capital
                                                   (continued...)
                               - 6 -

     The principal amount of the loans, for which the 12 future

lottery payments served as collateral, was $186,000, $100,000 of

which was used to construct or improve petitioners’ personal

residence.   There is no evidence in the record as to petitioners’

use of the other $86,000.   Petitioners’ residence did not serve

as additional collateral or security for the loans, and that

property was not mortgaged in connection with the loans.    The

$250,000 loan discharge payment consisted of $186,000 in

repayment of the loans and $64,000 of interest or of a

combination of interest plus penalties for early repayment.3

Petitioners seek to deduct the $64,000 payment, which, if

allowable, would partially offset the inclusion of the $400,000

paid by Woodbridge as consideration for the 12 future lottery

payments in gross income.




     2
      (...continued)
asset, its transfer would give rise to long-term capital gain.
See sec. 1222(3).
     3
        During the hearing, Peter acknowledged that some portion
of the $64,000 additional payment constituted a penalty for
prepayment of the loans. In his brief, respondent characterizes
the entire $64,000 as accrued interest. The distinction is of no
consequence because loan prepayment penalties are generally
treated as interest for Federal income tax purposes. See 12701
Shaker Blvd. Co. v. Commissioner, 

, 257-259 (1961),
affd. 

 (6th Cir. 1963) (loan prepayment penalty
deductible as interest in the year of payment); see also Lewis v.
Commissioner, 

, 630 (1975); Gen. Am. Life Ins. Co. v.
Commissioner, 

, 1268 (1956); Rev. Rul. 57-198, 1957-1
C.B. 94. Therefore, we shall treat the issue as solely involving
the deductibility of a $64,000 interest payment.
                                 - 7 -

                              Discussion

I.   The Capital Gain Issue

      The issue in dispute is whether the $400,000 that Mary

received in exchange for her assignment of the 12 future lottery

payments to Woodbridge is ordinary income or long-term capital

gain.     Resolution of that issue depends upon whether Mary’s right

to receive the 12 future lottery payments constitutes a capital

asset within the meaning of section 1221.

      The question of whether the right to receive future lottery

payments, which represent a portion of the total anticipated

payout, constitutes a capital asset does not present an issue of

first impression.    In Davis v. Commissioner, 

 (2002),

we held that the right to receive such payments does not

constitute a capital asset within the meaning of section 1221.4

In that case, we provided a thorough analysis of the caselaw

which led us to that result.    No purpose would be served by

repeating the legal analysis in Davis, and we refer to that

analysis in support of our holding herein that (1) petitioners’


      4
        In Davis v. Commissioner, 

 (2002), the
taxpayers assigned a portion of each of 11 future annual lottery
payments out of a total of 14 such payments that they were
entitled to receive. Id. at p.3. In this case, Mary assigned
all of the 12 future lottery payments, which also represented a
portion of the total future payments that she was entitled to
receive. We do not view that distinction as material, and we
view the lottery payment right assigned in Davis as, in
substance, identical to the lottery payment right assigned in
this case for purposes of deciding whether such right constitutes
a capital asset.
                               - 8 -

right to receive the 12 future lottery payments does not

constitute a capital asset within the meaning of section 1221,

and (2) the $400,000 received by petitioners from Woodbridge in

exchange for that right constitutes ordinary income.    Accord

United States v. Maginnis, 89 AFTR 2d 2002-3028, 2002-2 USTC par.

50,494 (D. Or. 2002).

II.   Deductibility of the $64,000 Interest Payment

      A.   Introduction

      During the hearing, Peter agreed that $100,000 of the

proceeds of the loans was used to construct or improve

petitioners’ personal residence, such residence was not used as

collateral for the loans, and no mortgage was placed on the

property in connection with the loans.   In light of those

stipulated facts, respondent argues that, with respect to

individuals, section 163(h)(1) denies any deduction for “personal

interest”, and that there is no evidence to indicate that

petitioners’ interest payments fall within any of the exceptions

to the definition of “personal interest” set forth in section

163(h)(2).5


      5
        Sec. 163(h)(2) defines “personal interest”, in pertinent
part, as follows:

           (2) Personal interest.--For purposes of this
      subsection, the term “personal interest” means any
      interest allowable as a deduction under this chapter
      other than--

                                                      (continued...)
                               - 9 -

     B.   Applicability of Section 163(h)(2)(D)

     In particular, respondent argues that petitioners’ interest

payments fail to satisfy the requirements for the exception

provided in section 163(h)(2)(D) for “qualified residence

interest”.   That is because, although petitioners’ principal

residence meets the definition of a “qualified residence” (see

sec. 163(h)(4)(A)(i)(I)), and although the loans constituted

“acquisition indebtedness” (which, pursuant to section

163(h)(3)(B)(i)(I), includes indebtedness “incurred in * * *

constructing, or substantially improving any qualified

residence”), repayment of the loans was not secured by such

residence as required by section 163(h)(3)(B)(i)(II).

     We agree with respondent that, based upon the stipulated

facts, the $64,000 interest payment does not constitute

“qualified residence interest” within the meaning of section

163(h)(2)(D) and (3).


     5
      (...continued)
              (A) interest paid or accrued on indebtedness
          properly allocable to a trade or business (other
          than the trade or business of performing services
          as an employee),

               (B) any investment interest (within the
           meaning of subsection (d)),

                *    *    *    *       *   *   *

               (D) any qualified residence interest (within
           the meaning of paragraph (3)),
                              - 10 -

     C.   Applicability of Section 163(h)(2)(A)

     Petitioners argue for the first time on brief that the

$64,000 interest payment is deductible under section 163(h)(2)(A)

as “interest paid or accrued on indebtedness properly allocable

to a trade or business”.   We assume that that argument represents

an attempt by petitioners to link the loans to Mary’s business

use of petitioners’ personal residence.   The Schedule Cs included

in petitioners’ returns for the audit years indicate that Mary

was engaged in a business (conducted on a cash basis)   referred

to variously as “model train painting” (1995) or “professional

custom painting” (1996).   The Form 8829, Expenses for Business

Use of Your Home, for 1995 states that 37.96 percent of

petitioners’ residence was used regularly and exclusively for

business.   For 1996, such business use percentage is stated to be

15.4 percent.

     As a general rule, this Court will not consider issues

raised by a party for the first time on brief when to do so will

prevent the opposing party from presenting evidence or arguments

that might have been offered had the issue been timely raised.

Graham v. Commissioner, 

, 423 (1982).   In this case,

respondent notified the Court of his intention not to file a

reply brief for the reason that his opening brief “adequately

disposes of the relevant factual and legal aspects of this case.”

Respondent has thereby failed to object to petitioners’ argument
                              - 11 -

on the basis of timeliness.   Therefore, we shall consider

petitioners’ argument on the merits.

     On the basis of the record before us, we decline to hold

that any portion of the $64,000 interest payment is deductible

pursuant to section 163(h)(2)(A).   In order to fall within that

provision, an interest payment must qualify as “[i]nterest

expense allocated to a trade or business expenditure”.   Sec.

1.163-8T(a)(4)(i)(A), Temporary Income Tax Regs., 52 Fed. Reg.

24999 (July 2, 1987).   A “trade or business expenditure” is one

that has been incurred “in connection with the conduct of * * *

[a] trade or business”.   Sec. 1.163-8T(b)(7), Temporary Income

Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987).   There is nothing

in the record to indicate that any portion of the loans was used

to modify or improve that portion of petitioners’ residence

devoted to the conduct of Mary’s business.   In fact, the Forms

8829 attached to the returns for the audit years indicate that

none of the proceeds of the loans was used for such purpose.6

Therefore, we find that no portion of the $64,000 interest




     6
        The Form 8829 for 1995 states that, out of a total area
of 3,240 square feet, 1,230 square feet were used “regularly and
exclusively” for business. According to the Form 8829 filed for
1996, the comparable figures are 4,090 square feet (total area)
and 630 square feet (business use area). Thus, while total area
increased between 1995 and 1996, presumably as a result of the
improvement paid for by a portion of the proceeds of the loans,
the amount devoted to business use decreased by almost 50 percent
during that same period.
                              - 12 -

payment is excepted from the definition of nondeductible

“personal interest” pursuant to section 163(h)(2)(A).

     D.   Applicability of Section 163(h)(2)(B)

     Petitioners’ Exhibit 13, placed in evidence during the

hearing, consists of a copy of the instructions for preparing

I.R.S. Form 4952, Investment Interest Expense Deduction (the Form

4952 instructions).   At the hearing, Peter noted that the Form

4952 instructions state that property held for investment

includes property that produces income from annuities.   Although

petitioners have failed to elaborate further, either at the

hearing or in their brief, we interpret Peter’s introduction of

the Form 4952 instructions as an attempt to argue that at least a

portion of the $64,000 interest payment is deductible as

“investment interest” pursuant to section 163(h)(2)(B), and, more

specifically, that such interest was “paid * * * on indebtedness

properly allocable to property held for investment” (i.e., the

annuity purchased by the Colorado State Lottery to fund the

lottery payments to Mary).   Sec. 163(d)(3)(A).

     Assuming that we have accurately described petitioners’

argument, we find it to be without merit.    The annuity allegedly

“held for investment” was held by the Colorado State Lottery, not

by Mary who incurred the interest expense.   More significantly,

petitioners explicitly stipulated that the loans, to the extent

of $100,000, were used to purchase or improve petitioners’
                              - 13 -

principal residence, which does not qualify as “property held for

investment”.   See sec. 163(d)(5)(A).   (As noted previously, there

is no evidence in the record as to petitioners’ use of the

$86,000 balance of the loans.)   Thus, the $64,000 interest

payment is not allocable to an “investment expenditure”, which is

defined, in pertinent part, as “an expenditure * * * properly

chargeable to capital account with respect to property held for

investment”.   See sec. 1.163-8T(a)(4)(C), (b)(3), Temporary

Income Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987).   As a

result, no portion of the $64,000 interest payment qualifies as

“investment interest” within the meaning of section 163(h)(2)(B).

     E.   Conclusion

     The $64,000 interest payment constituted the payment of

nondeductible “personal interest” under section 163(h).

     To reflect the foregoing,


                                          Decision will be entered

                                    under Rule 155.