BROADHEAD v. COMMISSIONER
25 T.C.M. 133; P-H T.C. Memo ¶66,026 (1966).

Key Topics
DISPOSAL WITH A RETAINED ECONOMIC INTEREST
· Treatment of cash basis taxpayer's basis recovery CAPITALIZATION OF SITE IMPROVEMENT EXPENDITURES
· Failure of proof
CASUALTY LOSS
· Timber partially destroyed by fire
· Land damage
OUTRIGHT SALE--CAPITAL GAIN v. ORDINARY INCOME
· Sales of timberland by sawmill operator

In 1955, the taxpayer granted two timber companies the right to cut standing timber owned by him. He received payments under these contracts in 1955 and 1956 which, after deduction of depletion, resulted in a loss to him. However, the taxpayer deducted the entire loss in 1956 when the cutting rights were terminated. The Commissioner contended that the loss should have been apportioned between 1955 and 1956 on the basis of the timber cut and paid for in each year. The taxpayer argued that the timber cutting contracts were speculative and that he was not required to report gain or loss until completion of the cutting.

In 1956, the taxpayer acquired an unimproved tract of timberland. In preparation for logging a marshy area, he acquired two draglines and employed them in ditching operations. A mortgage on the property required that a dragline be continuously engaged in the construction of canals and roadways. The taxpayer deducted as an expense the cost of freight and monthly installments paid on the draglines. The Commissioner disallowed these deductions, contending that the cost of the draglines should be capitalized and depreciated and that the allowable depreciation should be added to the cost of the land rather than deducted. The taxpayer conceded that the draglines were capital assets but contended that depreciation was allowable as a deduction.

In 1956, a fire swept 10,000 of the taxpayer's 73,000 acres of timberland in North Carolina. The taxpayer reported the loss of timber at $15 per acre and the loss from damage to the land at $2.84 per acre, computing a total casualty loss of $178,400. The taxpayer took the position that he was entitled to deduct the loss in value limited only by his basis in the entire 73,000 acres. The Commissioner allocated the taxpayer's basis in the 73,000 acres between land and timber, determining a basis of $13.77 per acre in timber and a basis of $3.43 per acre in the land. He ascertained the acreage of timber and the acreage of land destroyed, assigned the above basis, and computed a casualty loss of only $35,413. The taxpayer conceded that basis should be allocated between timber and land, but contended that a much greater portion of the property had been destroyed.

Most of the timber cut by the taxpayer from his extensive holdings was used in his sawmill operations. On a few occasions, he sold tracts or cutting rights to various purchasers. Most of these sales were made when cash was required to meet charges on the land or when sawmill operations were unprofitable. The taxpayer did not solicit purchasers, hold himself out as a dealer in timberlands, or advertise timberlands for sale. The sales were not numerous and many were made to the same buyer, who sought out the taxpayer and requested that the sales be made. The taxpayer sold three tracts of land in 1958 and one in 1959 and reported his profit as capital gain. The Commissioner contended that the taxpayer was in the trade or business of buying and selling timberland and reclassified the gain as ordinary income.

Held: For the Commissioner. Although in some highly speculative sales situations a cash basis taxpayer need not report income until he has received payments in excess of his basis, that principle has no relevance to a disposal of timber under a cutting contract with a retained economic interest. Under such a contract, the seller recovers his basis through a depletion deduction as the timber is cut. The yearly depletion allowance is based on the timber severed in each year, and the taxpayer has shown no error in the Commissioner's computation.

Held: For the Commissioner. Without deciding the validity of his position that depreciation on equipment during the course of construction must be capitalized, the Court sustains the Commissioner as a consequence of the taxpayer's failure of proof. It may be speculated that the property was being improved for use in the taxpayer's business, but the taxpayer failed to show that this development had progressed to the point of being a business in 1957.

Held: The taxpayer is entitled to deduct as a casualty loss $83,002. After considering all of the testimony, the qualifications of the witnesses, and other evidence, the Court concludes that the fire damaged 600 acres of the taxpayer's land to such an extent that it was no longer valuable for the growing of timber, and it accepts the allocation of basis to the land of $3.47 per acre. It finds that all of the timber on 1,600 acres, 60% of the timber on 2,800 acres, and 500 of the timber on 5,000 acres was destroyed. It accepts neither the taxpayer's allocation of $15 per acre nor the Commissioner's allocation of $13.77 per acre to the timber. The taxpayer did not explain his claim of $15 per acre and the Commissioner's computation of $13.77 per acre failed to reflect the fact that only pine was destroyed. The Court finds the basis of the timber to be $14 per acre.

Held: For the taxpayer. Whether the taxpayer was engaged in the trade or business of selling timberlands is a question of fact involving consideration of factors such as the purpose of the taxpayer in acquiring the property, the frequency, continuity, and substantiality of sales, and the extent of the taxpayer's activity in improving the property, advertising it for sale and soliciting purchasers. Based on these guidelines, it is clear that the taxpayer was not engaged in the trade or business of selling timberland, and his profits were capital gains. The taxpayer was engaged in the trade or business of selling timber, but not that of selling timberland. He sold timberland only when the expense of holding it became burdensome or when a part of his sawmill operation became unprofitable. He did not hold himself out as a dealer, nor did he advertise timberland for sale.

SCOTT, Judge: Respondent determined deficiencies in petitioners' income tax for the calendar years 1956, 1958, 1959, and 1960 in the amounts of $19,030.53, $123,983.46, $499,066.30, and $463,389.89, respectively.

Some of the issues raised by the pleadings have been disposed of by agreement of the parties leaving for our decision the following:

1. With respect to the year 1956:

A. Whether losses on the sale of timber which was cut during the years 1955 and 1956 under contracts entered into in 1955 should be apportioned between the two years on the basis of the timber cut in each year or reported in full for the year 1956 when the contracts were completed.

B. Whether petitioners are entitled to the standard deduction for the year 1956 or are not entitled to that deduction because of being allowed a deduction for interest paid on Federal income tax deficiencies in an amount greater than the standard deduction, which amount represents at least to the extent of the standard deduction a personal and not a business deduction.

2. With respect to the year 1957 the following issues arise for the purpose of determining the basis of property sold in other years and whether petitioners had a net operating loss to carry back to 1956 since respondent determined no deficiency for this year:

A. Whether petitioners are entitled to a deduction for depreciation on machinery used in making capital improvements to timberlands owned by them.

B. Whether the amount of $11,664.84 paid by petitioners as State income tax is a proper deduction in arriving at adjusted gross income or is properly deductible only from adjusted gross income.

C. What is the proper amount of deduction to which petitioners are entitled as a casualty loss because of damage done to some of their timber and timberlands by a forest fire.

3. With respect to the year 1958:

A. Whether amounts totaling $9,636.71 spent by petitioners in connection with certain oil leases are deductible or constitute nondeductible capital expenditures.

This same issue is present with respect to payments totaling $123,245.89 in the year 1959 and payments totaling $9,270.07 in the year 1960.

B. Whether petitioners' payment of $9,945 in discharge of their

guarantee of an obligation of Delta Hardwood Lumber Company resulted in a business or nonbusiness bad debt.

C. In computing the profits taxable to petitioners from an installment sale, which they elected to report on such basis, of certain timberlands located in North Carolina, whether the sales price Of the property should be reduced by the mortgages assumed by the purchaser in arriving at the contract price for the purpose of determining the applicable gross profit ratio.

D. Whether gains realized by petitioners which were reported on the installment basis from the sale of three parcels of land in 1958, referred to as the Togo Island tract, the Arkansas tract, and the North Carolina timberlands, constitute ordinary income or long-term capital gain.

This same issue is present with respect to the year 1959 as to further payments which were received in that year from the 1958 sales of these properties and as to sales of Louisiana properties in 1959.¹

4. With respect to the year 1959:

A. When an obligation owed to petitioners by Michael Eubanks in the amount of $46,000 became worthless, were petitioners entitled to a deduction of a business or nonbusiness bad debt?

B. Whether petitioners collected the amount of $397,000 of the sales price of the Togo Island tract and Arkansas tract upon the refinancing of these properties by the purchaser with petitioners' assistance, funds from the proceeds of the new mortgage being used to this extent to discharge a prior mortgage which had been placed on the property by petitioners but assumed by other persons.

5. With respect to the year 1960:

A. Whether petitioners had a gain in the amount of $445,411.14 or any portion thereof upon their repossession of Togo Island, the Arkansas lands, and the Avoyelles tract in Louisiana. The determination of this issue requires both the determination of petitioners' basis in the notes secured by the mortgages which were foreclosed on these properties and the fair market value of these properties at the date of foreclosure.

B. Whether petitioners are entitled to a deduction for interest paid because of their payment on August 2, 1960, of an installment including $48,419.08 of interest, due by Michael Eubanks on a first mortgage on property on which petitioners had instituted foreclosure proceedings under a second mortgage in July 1960 which resulted in petitioners' repossession of the property subsequent to August 2, 1960, and for $2,966.28 of expenses of the mortgagor which had been advanced by the mortgagee.

6. Whether petitioners sustained a net operating loss in 1957 which constitutes a net operating loss deduction in the year 1956.

Some of the facts have been stipulated and are found accordingly. Sam E. Broadhead (hereinafter referred to as petitioner although he died during the trial 'of this case and his executors have been substituted as petitioners) and Verdie Cox Broadhead, husband and Wife residing in Meridian, Mississippi, filed joint Federal income tax returns for each of the calendar years 1955, 1956, 1957, 1958, 1959, and 1960 with the district director of internal ·revenue at Jackson, Mississippi.²

Sam E. and Verdie Cox Broadhead (hereinafter jointly referred to as petitioners) came to Mississippi in 1939 and from that time until at least the date in 1951 when they sold 26,000 acres of land located in Clarke County, Mississippi, were engaged in sawmill operations.³

In 1951 petitioners sold 26,000 acres of timberland located in Clarke County, Mississippi to International Paper Company in order to obtain funds with which to pay an income tax deficiency. After the sale of this land petitioners owned no timber acreage until later in that year when they began to acquire various timberlands.

After the sale of the 26,000 acres of timberlands in 1951, petitioners began to acquire other timberlands. The following schedule Shows the purchases and sales of timberlands by petitioners as reflected on their income tax returns, together with the purchase price, sales price, and persons to whom sold, to the extent these facts appear in the record, during the years 1955 through 1960:

1 Partial sale of tract. Waterloo Dairy consisted of agricultural land as well as timberlands.

The Arkansas lands, Togo Island, and the Avoyelles tract were subsequently repossessed from Eubanks as follows:

The Arkansas lands and Togo Island were still subject to first mortgages to Connecticut General Life Insurance Company when petitioners foreclosed on their second mortgages.

The lands were subjected to the following mortgages or deeds of trust during the years here in issue:

Facts with Respect to the 1955-1956 Timber Cutting Contract

On May 23, 1955, petitioners entered into a purchase contract for all merchantable timber on certain land in Louisiana (hereinafter referred to as the Mack Pope tract) for $250,000 plus agents' fees of $2,412.57. On August 15, 1955, petitioners executed a sales contract with Charles L. Rogers, providing for a deposit and prescribed settlement terms, and giving to Rogers the right to cut all merchantable pine cypress on the Mack Pope tract, the timber to be paid for by Rogers as cut. On October 22, 1955, petitioners entered into a contract with Johnie Rogers and Tom Forbes under the terms of which Johnie Rogers and Tom Forbes were to cut the merchantable hardwood timber located on this same tract, the timber to be paid for as cut under terms similar to the terms of the contract with Charles L. Rogers.

During 1955, petitioners received under both contracts a total amount of $119,362.87 in settlement for 2,734,451 feet board measure of timber. During 1956 petitioners received under both contracts a total amount of $124,467.88 in settlement for 2,800,969 feet board measure of timber.

Petitioners claimed a loss on their 1956 Federal income tax return from these two timber-cutting contracts in the total amount of $33,581.82, but at the trial agreed that this amount was in error and the total loss under the two contracts was $8,581.82. Respondent takes the position that this total loss is applicable to the years 1955 and 1956 on the following basis:

Petitioners on their 1956 Federal income tax return deducted as a business expense interest paid of $73,247.34. Respondent in his notice of deficiency disallowed the standard deduction of $1,000 claimed by petitioners with the explanation that inasmuch as petitioners deducted personal interest of several thousand dollars paid on a Federal income tax deficiency and also claimed a standard deduction of $1,000, they had been given the most advantageous election of itemized deductions and the standard deduction of $1,000 had been disallowed.

In 1956 petitioners purchased two draglines for a total amount of $38,519 for use in ditching and improving a certain tract of land in Hyde County, North Carolina, which they had purchased in 1956. The draglines were needed for use in ditching on the property as preparation for logging a marshy area.

In a mortgage placed by petitioners on the Hyde County, North Carolina property in October 1957, the following provision appears:

Grantor shall at ail times keep upon the property described in this instrument at least one dragline which is in good operating condition and which has a capacity of at least s/s cubic yard. Said dragline shall be continuously engaged during normal working hours in the construction of canals and roadways of a type which conform to the standard practices in the locality. Normal and ordinary work stoppages for repairs, or stoppages occasioned by Acts of God, shall not constitute a default hereunder.

Petitioners on their income tax return deducted as an expense the cost of freight and monthly installments paid on the two draglines. Respondent disallowed this deduction and determined that the drag-lines were a capital asset with a salvage value of $8,000 and a useful life of 5 years, resulting in depreciation during the year 1957 of $6,103.80. Respondent determined that the depreciation on the two draglines should be capitalized and added to: the cost of the land being improved. Petitioners now concede that the $6,103.80 as determined by respondent is the proper amount for depreciation on these two draglines in 1957 but contend that this amount of depreciation is a deductible expense in that year and is not to be capitalized and added to the land cost.

During 1957 petitioners paid $11,664.84 of deductible State income taxes. Petitioners did not claim this deduction on their 1957 Federal income tax return. Respondent concedes that the amount is deductible and the only issue is whether it is deductible in arriving at adjusted gross income or is deductible only from adjusted gross Income.

In August 1957 a forest fire swept a portion of the North Carolina timberlands purchased by petitioners in 1956. The total acreage of the land which petitioners purchased in North Carolina in 1956 was 73,493 acres, and as of August 1957 petitioners' basis in the total property was $1,264,206,23. The timber area affected by the fire was approximately 10,000 acres with some additional acres of salt marsh area adjacent to the timber area also being affected. United States Highway 264 divided the acreage which was affected by the August 1957 forest fire. One portion of the affected acreage was located northwest of that highway and the other portion was located southeast of the highway. The northwest parcel of land affected by the fire contained approximately 4,400 acres. The southeast portion of the land affected by the fire comprised approximately 5,700 acres and a portion of this acreage was marshland that did not support a stand of timber.

In connection with the purchase of this same North Carolina property from petitioners in 1958 by the Powe interests, E. Wheeler Bryant, who has managed, bought, and sold timberlands in Mississippi for approximately 48 years and is a registered consulting appraiser of timberland, inspected this property in approximately July of 1957 before the August fire and he inspected it again in 1958 after the fire had occurred.

The purchase price paid for the entire 73,493 acres in 1958 was $2,41.9,000 and the purchasers considered the value of the timber on the average as being the equivalent of from $25 to $30 per acre in determining the purchase price they were willing to pay. The timber cruise of this acreage in 1956 showed 91 million feet of standing timber.

The timber on the acreage which was burned was all pine, primarily Pond pine, although the tract as a whole contained other timber. Approximately 70 million board feet of the timber on the total North Carolina tract was pine, 20 million board feet was hardwood and cypress, and 1 million board feet was juniper. The timber growth on the acreage affected by the fire was about average for the tract as a whole. Not all of the timber on the acreage swept by the fire was killed. On the acreage northwest of Highway 264 all of the merchantable timber was destroyed on 1,600 acres and approximately 60 percent of the timber was destroyed on the balance of the acreage. Approximately 50 percent of the timber on the portion east and south of the highway was killed. Since the 1957 fire some new growth of timber has developed on the burned area, but on approximately 600 acres no new growth has appeared. This 600 acres was subjected to ground and subsurface fire which destroyed certain of the organic materials in the soil making it useless for growing timber.

It was not economically feasible to salvage the damaged timber which was burned but not completely destroyed on the acreage affected by the fire in 1957 because the location of the acreage and the burned timber thereon was such that the cost of that operation would exceed the value of the timber salvaged.

Petitioners on their income tax return for 1957 reported loss of timber on the 10,000 acres affected by the fire on the basis of $15 per acre cost and loss of land for the same acreage on the basis of $2.84 per acre, showing a total casualty loss of $178,400.

The fair market value of the portion of petitioners' land affected by the fire in 1957 was approximately $200,000 greater before the fire than after the fire.

Respondent determined that as of the date of petitioners' purchase of the North Carolina property in 1956 the fair market value of the pine timber thereon was $15 per thousand board feet, the fair market value of the hardwood and cypress timber thereon was $10 per thousand board feet, the fair market value of the juniper thereon was $30 per thousand board feet, the fair market value of the land itself was $5 per acre, and the fair market value of the young growth on the land was $2,50 per acre. In accordance with this determination respondent allocated petitioners' basis in the North Carolina tract between land, young growth, and timber as follows:

Respondent determined that the fire in Hyde County destroyed the equivalent of 2,425 acres of merchantable timber having a basis to petitioners of $29,221.25 and 3,000 acres of young growth having a basis to petitioners of $6,192, making a total casualty loss as determined by respondent of $35,413.25.

Petitioners now apparently do not contest respondent's method of computing the casualty loss but claim a loss from the fire of $114,582, which is composed of a cost of 600 acres of land which suffered organic soil destruction of $3.47 per acre for a total of $2,082, and a cost of pine timber on the basis of $15 per acre determined on a basis of 1,000 board feet per acre of Pond pine with 6,000 acres being a total loss and 3,000 acres at 50 percent loss.

Sometime prior to 1958, petitioner had commenced purchasing certain oil and gas rights. In 1958 petitioners expended amounts in connection with certain drilling leases. Of the expenditure, $486.71 represented expenses for maps and recording of leases and other miscellaneous expenditures in connection with leases and $9,150 represented the payments made at the time the leases were entered into with respect to 18 separate leases of terms ranging from 5 to 10 years carrying provisions for payment of delay rentals if drilling were not commenced in the first year of the term of the lease. The largest payment of the 18 leases was with respect to a lease executed on December 4, 1958, between petitioner and the Board of Supervisors of Clarke County, Mississippi, the payment being in the amount of $3,200. The following language appeared in this lease:

THIS AGREEMENT made this 4th day of December 1958, between the Board of Supervisors of Clarke County, Mississippi, Lessor (whether one or more) whose address is: Quitman, Mississippi and Sam Broadhead, Meridian, Mississippi, Lessee, WITNESSETH:

1. Lessor in consideration of THREE THOUSAND TWO HUNDRED AND NO/100 Dollars ($3,200.00), in hand paid. of the royalties herein provided, and of the agreement of Lessee herein contained, hereby grants, leases and lets exclusively unto Lessee for the purpose of investigating, exploring, prospecting, drilling and mining for and producing oil, gas and all other minerals, laying pipe lines, building roads, tanks, power stations, telephone lines and other structures thereon to produce, save, take care of, treat, transport and own said products, and housing its employees, the following described land in Clarke County, Mississippi, to-wit:

* * *

2. Subject to the other provisions herein contained, this lease shall be for a term of six years from this date (called "primary term") and as long thereafter as oil, gas or other mineral is produced from said land or lands with which said land is pooled hereunder.

3. The royalties to be paid by Lessee are: (a) on oil, one-eighth of that produced and saved from said land, the same to be delivered at the wells or to the credit of Lessor into the pipe line to which the wells may be connected; Lessee may from time to time purchase any royalty oil in its possession, paying the market price therefor prevailing for the field where produced on the date of purchase, in either case such interest to bear its proportion of any expense of treating unmerchantable oil to render it merchantable as crude; (b) on gas, including casinghead gas or other gaseous substance, produced from said land and sold or used off the premises or in the manufacture of gasoline or other product therefrom, the market value at the well of one-eighth of the gas so sold or used, provided that on gas sold at the wells the royalty shall be one-eighth of the amount realized from such sale; where gas from a gas well is not sold or used, Lessee may pay as royalty $100.00 per well per year and if such payment is made it will be considered that gas is being produced within the meaning of Paragraph 2 hereof; and (c) on all other minerals mined and marketed, one-tenth either in kind or value at the well or mine, at Lessee's election, except that on sulphur mined and marketed, the royalty shall be fifty cents (50¢) per long ton, Lessee shall have free use of oil, gas, coal, wood and water from said land, except water from Lessor's wells, for all operations hereunder, and the royalty on oil, gas and coal shall be computed after deducting any so used. Lessor shall have the privilege at his risk and expense of using gas from any gas well on said land for stoves and inside lights in the principal dwelling thereon out of any surplus gas not needed for operations hereunder.

* * *

5. If operations for drilling are not commenced on said land or on acreage pooled therewith as above provided on or before one year from this date the lease shall then terminate as to both parties, unless on or before such anniversary date Lessee shall pay or tender to Lessor or to the credit of Lessor in Bank of Quitman at Quitman, Mississippi (which bank and its successors are Lessor's agent and shall continue as the depository /or all rentals payable hereunder regardless of changes in ownership of said land or the rentals) the sum of SIX HUNDRED FORTY AND NO/100 DOLLARS ($640.00), herein called rental), which shall cover the privilege of deferring commencement of drilling operations for a period of twelve (12) months. In like manner and upon like payments or tenders annually the commencement of drilling operations may be further deferred for successive periods of twelve (12) months each during the primary term. The payment or tender of rental may be made by the check or draft of Lessee mailed or delivered to Lessor or to said bank on or before such date of payment. If such bank (or any successor bank) should fail, liquidate or be succeeded by another bank, or for any reason fail or re/use to accept rental, Lessee shall not be held in default or failure to make such payment or tender of rental until thirty (30) days after Lessor shall deliver to Lessee a proper record able instrument, naming another bank as agent to receive such payment or tenders. The down cash payment/s consideration for this lease according to its terms and shall not be allocated as mere rental for a period. Lessee may at any time or times execute and deliver to Lessor or to the depository above named or place of record a release or releases covering any portion or portions of the above described premises and thereby surrender this lease as to such portion or portions and be relieved of all obligations as to the acreage surrendered, and thereafter the rentals payable hereunder shall be reduced in the proportion that the acreage covered hereby is reduced by said release or releases.

Most of the remaining 17 leases entered into between various individuals and petitioner in 1958 with respect to which the remaining portion of the total sum of $9,636.71 was paid contained provisions similar to those quoted above.

In 1959 petitioners also expended amounts in connection with various mineral leases, which included $113,738.60 paid out at the time certain leases in Clark County, Wayne County, and Araire County, Mississippi, and Avoyelles Parish, Louisiana, were entered into. In addition to the $113,738.60 payments which petitioners deducted in computing their taxable income, they also claimed a deduction of 9,507.29 "mineral lease expense" in connection with these leases.

In 1960 petitioners expended $28,495.26 in connection with the acquisition and retention of mineral rights leases. Of this amount, $9,270.07 represented payments at the time the following leases were acquired:

* No delay rental provisions are contained in these leases.

** Respondent disallowed only $9,270.07 of this amount.

The leases, with the exception of the four St. Helena Parish, Louisiana leases and the deletion of the delay rental provisions as noted, contained provisions similar to those contained in the lease with the Board of Supervisors of Clarke County, Mississippi, quoted heretofore. The St. Helena Parish, Louisiana leases contained the following provisions:

THIS AGREEMENT, entered into effective as of February 10, 1960, by and between JOHNNIE B. LEE,

once married and then to Miss Ruth Lee, nee Lee, with whom he is living and residing, Address: Osyka, Mississippi, Route 2, herein called "Lessor" (whether one or more) and J. E. Stack, Jr., and Sam E. Broadhead, of Meridian, Mississippi, hereinafter called "Lessee," witnesseth, that:

Lessor, in consideration of the sum of Ten Dollars & other valuable considerations ($10,00); hereby leases and lets unto Lessee, the exclusive right to enter upon and use the land hereinafter described for the exploration for, and production of oil, gas, sulphur and all other minerals, together with the use of the surface of the land for all purposes incident to the exploration for and production, ownership, possession, storage and transportation of said minerals (either from said land or acreage pooled therewith), and the right to dispose of salt water, with the right of ingress and egress to and from said lands at all times for such purposes, including the right to construct, maintain and use roads, pipelines and/or canals thereon for operations hereunder or in connection with similar operations on adjoining land, and including. the right to remove from the land any property placed by Lessee thereon, and to draw and remove casing from wells drilled by Lessee on said land; the land to which this lease applies and which is affected hereby being situated in St. Helena Parish, Louisiana, and described as follows, to-wit:

* * *

This lease shall be for a term of five years and no months from the date hereof (called "primary term") and so long thereafter as oil, gas or some other mineral is being produced or drilling operations are conducted either on this land or on acreage pooled therewith (or with :any part thereof), all as hereinafter provided for; all subject to the following conditions and agreements:

1. This lease shall terminate on February 10, 1961, unless on or before said date the Lessee either (1) commences operations for the drilling of a well on the land, or on acreage pooled therewith (or with any part thereof), · in search of oil, gas or other minerals and thereafter continues such operations and drilling to completion or abandonment; or (2) pays to the Lessor a rental of One and No/100 ......... Dollars ($1.00) per acre for all or that part of the land which Lessee elects to continue to hold hereunder, which payment shall maintain Lessee's rights in effect as to such land without drilling operations for one year from the date last above mentioned; and Lessee may continue to maintain the rights granted without drilling operations for successive twelve months' periods (during the primary term) by paying Lessor, on or before the beginning of such respective periods One and No/100 ......... Dollars ($1.00) per acre for all or that part of the land held hereunder, Payments may be made to the Lessor or may be mailed or delivered for deposit to Lessor's credit in the Bank of Greensburg, Greensburg, Louisiana, which Bank or its successor shall continue to be the depository for such rentals as the representative of Lessor and Lessor's successors and assigns; and the death or incapacity of Lessor shall not terminate or affect Lessee's right to continue to deposit all payments in said depository bank or its successor. The mailing of the check or draft of Lessee or Lessee's successors to Lessor at the address set forth above or to said Bank on or before the rental paying date shall be considered as payment of rental and operate to maintain Lessee's right in force and effect. Should said Bank fail or liquidate, or if it should for any reason fail or refuse to accept Lessee's check or draft, the attempted payment in the manner above provided shall not be thereby rendered ineffective and Lessee shall not be in default for failure to pay said rental until thirty (30) days after Lessor shall have furnished Lessee with a recordable instrument naming a new depository; and this provision shall apply to all such new and subsequently named depositories. Wherever used in this lease, "operations for drilling," "drilling operations'' and "operations" shall be deemed to have been commenced when work is commenced or materials placed on the ground at or near the well site preparatory to the drilling of a well.

* * *

7. Subject to the provisions of Paragraphs 2 and 10 hereof the royalties to be paid by Lessee are: (a) on oil (which includes condensate and other liquid hydrocarbons when separated by lease separator units), one-eighth (1/8) of that produced and saved from the land and not used for fuel in conducting operations on the property (or on acreage pooled therewith or with any part thereof), or in treating such liquids to make them marketable; (b) on gas, one-eighth (1/8) of the market value at the well of the gas used by Lessee in operations not connected with the land leased or any pooled unit containing all or a part of said land; the royalty on gas sold by Lessee to be one-eighth (1/8) of the amount realized at the well from such sales; (c) one-eighth (1/8) of the market value at the mouth of the well of gas used by Lessee in manufacturing gasoline or other by-products, except that in computing such value, there shall be excluded all gas or components thereof used in lease or unit operations, or injected into subsurface strata as hereinafter provided; (d) One Dollar ($1.00) for each ton of 2240 pounds of sulphur, payable when marketed; and (e) one-eighth (1/8) of the market value at the well or mine of all other minerals produced and saved or mined and marketed. Oil royalties shall be delivered to Lessor free of expense at Lessor's option in tanks furnished by Lessor at the well or to Lessor's credit in any pipe line connected therewith. In the event Lessor does not furnish tanks for such royalty oil and no pipe line is connected with the well, Lessee may sell Lessor's such oil at the best market price obtainable and pay Lessor the price received f.o.b, the leased property, less any severance or production tax imposed thereon. Lessee shall have the right to inject gas, water, brine or other fluids into subsurface strata, and no royalties shall be due or computed on any gas or component thereof produced by Lessee and injected into subsurface stratum or strata through a well or wells located either on the land or on a pooled unit containing all or a part of the land.

Petitioners on their income tax returns for each of the years 1958, 1959, and 1960 claimed deductions as business expenses of :the mounts expended with respect to the various leases acquired. Respondent disallowed $9,636.71, $123,245.89, and $9,270.07 for the years 1958, 1959, and 1960, respectively, with the explanation that such amounts were expenditures in acquiring leases which should be capitalized.

Delta Hardwood Lumber Corporation Bad Debt

In the latter part of 1953 petitioner was considering commencing, during 1954, cutting timber from acreage he owned in Arkansas through two operating companies which were Delaware corporations of which he was the sole stockholder, Delta Oak Flooring Company and Quitman Veneer Company. Petitioner submitted his plan to respondent on November 30, 1953, and received a ruling that the gains from such an operation would be recognized as capital gains from the sale of timber.

Petitioner did not go through with the plan in accordance with the proposal of November 30, 1953, but in 1957 petitioner wrote the district director of internal revenue that he then proposed that a Delaware corporation owned by his children and financed by him, Delta Hardwood Lumber Corporation (hereinafter referred to as Delta) would operate a sawmill for the production of timber from his land. In 1957, at the time the letter was written to the district director of internal revenue, the sawmill was nearing completion and the plan contemplated that Delta would produce lumber to be sold exclusively through the Wells Lumber Company (hereinafter referred to as Wells) of Montgomery, Alabama. Wells was to advance money to Delta to enable it to produce the lumber and be repaid from the lumber as it was produced. Petitioner guaranteed repayment of advances from Wells to Delta and, in accordance with this guarantee, in 1958 paid to Wells $9,945 consisting of $9,000 principal repayment and $945 of interest.

Petitioners on their 1958 income tax return deducted the $9,945 paid to Wells in accordance with petitioner's guarantee of advances by Wells to Delta with the following explanation:

Loss by payment of note and interest guaranteed by taxpayer as a step in sale of extensive timber stands owned by taxpayer.

Respondent in his notice of deficiency disallowed the claimed deduction of $9,945 with the explanation that the loss sustained by petitioners by reason of petitioner's having paid the obligation of Delta, of which he was the guarantor, was a nonbusiness bad debt, to be considered as a short-term capital loss.

During 1958, petitioners sold three parcels of land as heretofore set forth in the schedule of their purchases and sales of land. The Togo Island tract which had been purchased by petitioners in 1954 for $256,153.50 and which consisted of approximately 6,100 acres in Louisiana and 640 acres in Mississippi, was sold by petitioners February 1958 to M. J. Eubanks (hereinafter referred to as Eubanks) for a total consideration of $462,500. This sale was made subject to an outstanding mortgage held by Adele Sawyer, James E. Sawyer, and Susan Mason (hereinafter referred to as the Sawyer group) in the approximate amount of $175,000, which debt was not assumed by Eubanks. During 1958 collections on the sale of the Togo Island property totaled $87,364.51. At the date of the sale of this property by petitioners to Eubanks, petitioners' basis in the property was $236,725.14, representing its initial cost to petitioners less a casualty loss claimed and allowed in the amount of $19,428.36.

During the years 1951 through 1956 petitioners had purchased tracts of land located in Arkansas consisting of a total of approximately 21,528.35 acres as heretofore set out in the schedule of petitioners' purchases and sales of land. This property is referred to as the Arkansas tract. There was outstanding on one of these tracts consisting of approximately 14,280 acres, a mortgage of approximately $200,000 securing an indebtedness of petitioners to the Florida Real Estate Loan Company, the note evidencing the indebtedness being dated December 1, 1954.

In October 1957, petitioners borrowed $825,000 from Connecticut General Life Insurance Company (hereinafter referred to as Connecticut General) for which their personal note was given secured by a first mortgage on the North Carolina tract. Petitioners borrowed $425,000 from Connecticut General, giving therefor their personal note secured by a first mortgage on the Arkansas tract. The first mortgage on the North Carolina tract was, by its terms, also a second mortgage on the Arkansas tract, and the first mortgage on the Arkansas tract was, by its terms, also a second mortgage on the North Carolina tract. A portion of the $1,250,000 so borrowed by petitioners was used to pay the remaining balance on the note given by petitioners at the time of purchase of the North Carolina tract which was held in 1957 by Central Standard Life Insurance Company of Chicago. After payment by check of Connecticut General of this balance which was in the amount of $859,444.51, the remaining portion of the $1,250,000 borrowed by petitioners was disbursed by Connecticut General as follows: $161,821.11 was used to pay the balance due on the original note of $200,000 given by petitioners to Florida Real Estate Loan Company secured by deed of trust on a portion of the Arkansas tract, $3,490 was used to pay attorneys' fees, and the residue of $225,244.38 was disbursed to petitioners.

On July 13, 1958, petitioners sold the Arkansas tract to Eubanks for a total consideration of $1,625,000. Of this purchase price, $1,525,000 was discharged by a note from Eubanks to petitioners, secured by a deed of trust covering the Arkansas tract. The Arkansas tract had cost petitioners $437,307.08, which was petitioners' basis in the tract at the date of sale.

Collections on the sale of the Arkansas tract at the date of sale totaled $70,915.03. Petitioners incurred deductible legal expenses of $8,100 and other expenses of $60 in connection with this sale in 1958.

On August 5, 1958, petitioners sold the North Carolina tract to W. A. Powe, Bryant, and their associates (hereinafter referred to as the Powe group) for $2,419,250. As a part of the sales agreement, the Powe group assumed petitioners, outstanding mortgage indebtedness to Connecticut General aggregating $1,250,000 consisting of the two notes and mortgages of $825,000 and $425,000 described heretofore. The Powe group made a down payment of $229,250 and gave petitioners a note in the amount of $940,000 secured by a mortgage on the North Carolina tract.

Petitioners on their income tax return for the year 1958 reported total gain on the sale of the North Carolina tract of $1,152,930.83 arrived at by subtracting from the selling price of $2,419,000 a basis of $1,266,329.17.

Respondent in his notice of deficiency increased petitioners' basis in the property by the amount by which he decreased the casualty loss which had been claimed by petitioners with respect to the property in 1957, made certain other adjustments to basis not here in issue, and arrived at a corrected gross profit to be realized of $1,013,986.38.

Petitioners, in computing the gain ratio to be applied to the collections in 1958 from the sale of the North Carolina tract, used a percentage of 47.6, which was the percentage that their total computed gain was of the total selling price.

Respondent in his notice of deficiency computed a profit percentage of 86.72 by subtracting from the total selling price of $2,419,250 the mortgages assumed by the buyers of $1,250,000, arriving at a contract price of $1,169,250, and computing the percentage that the total gross profit to be realized (or total gain as referred to by petitioners) was of this computed contract price. He also recomputed the profit percentage on the Togo Island and Arkansas properties but petitioners offered no evidence and made no argument that there is error in these computations except to state that they do not agree with the method used by respondent.

Petitioners made the various purchases and sales of timberlands as heretofore set out including the three sales in 1958, the details of which are heretofore described, which are the only sales of timberlands in this year disclosed by the record. The record discloses no purchases of timberlands in 1958 or I959 by petitioners. Petitioners in 1959 sold a tract of timberlands they had acquired from the Sawyer group and on which there was outstanding an indebtedness of $250,000. The record discloses no sales of timberlands by petitioners in 1960.

In 1951 petitioners had sold the 26,000 acres of timberlands on which they had conducted a sawmill operation, in order to pay an asserted income tax deficiency. They then began to attempt to acquire a substantial amount of timber acreage which they hoped to increase to 100,000 acres of land debt free on which to continue to pursue sawmill operations. During the years 1954 through 1957 petitioners were also considering having wholly-owned corporations or corporations owned by their children enter into cutting contracts to cut the timber on certain of their timberlands. During the years here in issue petitioners sold varying amounts of timber. The sales made to Eubanks in 1958 were at the insistence of an individual employed by Eubanks who approached petitioners about the sale. Among the provisions of the deed from petitioners to Eubanks conveying the Arkansas property sold to him in 1958 were the following:

Sam Broadhead and his wife * * * hereby sell, convey, transfer and warrant, subject to the hereinafter stated conditions, limitations and/or reservations, unto M. I. Eubanks, and unto his heirs and assigns forever, the following described lands lying * * * in the State of Arkansas * * *

* * *

To have and to hold the foregoing unto said grantee and unto his heirs and assigns forever, subject to the foregoing, and hereinafter stated conditions, limitations and/or reservations.

There are two deeds of trust or mortgages outstanding against the described property * * * in favor of Connecticut General * * * These deeds of trust or mortgages contain limitations and provisions as to the cutting and removal of timber * * * Same shall be considered as a part hereof and abided by grantee herein.

Further, there is outstanding a document styled "supplemental Agreement" * * * Terms thereof shall be carried out.

It is contemplated that authority to cut timber from the described lands will be obtained from Connecticut General Life Insurance Company aforesaid and from grantors herein, and that timber shall only be cut strictly in accord with the terms of deeds of trust or mortgages aforesaid and supplemental agreement thereto, and further, only on and under terms set forth herein.

Area or areas shall be determined for the cutting of timber, and permission in writing from grantors and Connecticut General * * * before cutting of timber on any designated area begun * * * [S]uch area shall be cut according to good forestry practices, and in workmanlike manner, all trees on such area which will produce a log 10 feet long with 10 inch tip shall be cut, and always trees cut shall be taken into the top so long as log 10 feet long with 10 inch tip can be cut.

While cutting of timber is in progress on the described lands, and until the entire purchase price hereby required to be made has been paid in full, grantee shall pay adequate competent log scalers and checkers who shall be designated or approved, in writing, by grantors, and without expense to grantors. These log scalers and checkers shall make reports each week to grantors of all timber cut from the described premises, furnishing a copy of their report to grantee. These log scalers and checkers shall be employees of grantee, and he shall pay their salaries, their social security payments, and carry workmen’s compensation as to them.

* * *

Timber cut from described lands shall be paid for on basis of $25.00 per thousand feet for stumpage for tupelo gum, cypress, ash and hackberry, and $20.00 per thousand feet for stumpage on all other species.

The mortgage from Eubanks to Broadhead given at the time of the sale in 1958 contained substantially these same provisions.

The sale made to the Powe group was at the insistence of Bryant who approached petitioners about the sale. Petitioner's financial situation in 1958 was such that he was having difficulty meeting the charges, such as property taxes and interest on indebtedness, with respect to the various properties, particularly the North Carolina tract.

Petitioners reported the gains from the sales of the three tracts in 1958 and from the sale of the property sold in 1959 on the installment basis as capital gains: Respondent in his notice of deficiency determined that the gains from the sales of these tracts were ordinary income.

In July 1959 petitioners sold Eubanks a sawmill in Arkansas for $100,000 and lent him $50,000 with which to commence operation of this mill. Eubanks gave petitioners a note dated July 8; 1959, for the $150,000 to be repaid commencing July 15, 1959, at a minimum rate of $1,000 a week until the principal and 3 percent interest was paid in full. This note was secured by a deed of trust on the sawmill and certain timberlands in Mississippi. During 1959 Eubanks repaid to petitioner $4,000 of the $50,000 advance to be used in operating the sawmill.

When Eubanks defaulted on payment of the loan, petitioners foreclosed on the sawmill to effect payment of the $100,000, but found that the timberlands on which they held the deed of trust to secure their loan were subject to a prior mortgage given by Eubanks to another lender who had previously foreclosed, and they were therefore unable to collect the remaining $46,000.

Petitioners deducted the $46,000 on their 1959 income tax return as a business bad debt. Respondent recognized that the $46,000 constituted a bad debt but allowed it only as a nonbusiness bad debt deductible as a short-term capital loss.

Sometime late in 1958 Eubanks, with petitioner's assistance, negotiated with Connecticut General with respect to rearranging his indebtedness with respect to the Arkansas and Togo Island properties which he had purchased from petitioners in 1958 for the respective amounts of $462,500 and $1,625,000. Included as a portion of the rearrangement of Eubanks' indebtedness was also the financing of a tract of approximately 14,000 acres of timberland located in Arkansas and a timberland lease which Eubanks had arranged to purchase from E. A. Stewart Lumber Company, which properties are hereinafter referred to as the Stewart tract and the Pickthorne lease. The total consideration which Eubanks was to pay for the Stewart tract and Pickthorne lease was $635,491.95. The total amount of the loan to Eubanks by Connecticut General was to be $1,825,000.

The security for the $1,825,000 was to consist of a first mortgage on the Togo Island tract, the Arkansas tract, the Stewart tract, and the Pickthorne lease. Since there already existed a first mortgage on the Togo Island tract running to the Sawyer group, and a first and second mortgage on the Arkansas tract running to Connecticut General, as well as mortgages on both of these tracts securing the note given by Eubanks to petitioners in connection with the 1958 purchases of the properties, it became necessary to rearrange all of this indebtedness to complete the entire transaction.

The first mortgage on the Arkansas tract which ran to Connecticut General had been given by petitioners to secure $425,000 which petitioners had borrowed from Connecticut General, which mortgage the Powe group had agreed to assume as a part of the purchase price of the North Carolina tract. Payment had been made by the Powe group on this mortgage so that as of February 1959 when the rearrangement of indebtedness was affected there remained an outstanding principal balance on this mortgage of $397,000 and interest of $12,505.50 was due on the principal balance.

Since the agreement to assume the $425,000 first mortgage to Connecticut General on the Arkansas tract, which amount was also a second mortgage on the North Carolina tract, had been considered as a part of the purchase price of the North Carolina tract by the Powe group, it became necessary, if this mortgage to Connecticut General was to be paid out of funds other than moneys of the Powe group, for the Powe group to replace in some manner this portion of the purchase price of the North Carolina property, since as a result of the transaction the Powe group would owe to Connecticut General on their mortgage assumptions in connection with their purchase of the North Carolina property only $773,000 consisting of the $825,000 first mortgage on the North Carolina property which they had assumed less $52,000 which the Powe group had paid thereon in 1958. At the time of the rearrangement, the Powe group owed to petitioners on the note given to them at the time the North Carolina property was purchased the amount of $940,000. This note for $940,000 was to be paid to petitioners by annual installments of principal of $156,000 with a stated annual required interest payment. The Powe group was being released from $397,000 of indebtedness to Connecticut General assumed by them as part payment to petitioners for the North Carolina property, because of that amount of the proceeds from the loan by Connecticut General to Eubanks being used to pay off the principal amount of the first mortgage on the Arkansas properties which was also a second mortgage on the North Carolina property then held by Connecticut General. The Powe group agreed to and did execute a new note to petitioners for $1,337,000 replacing the $940,000 note given in part payment of the North Carolina property plus the $397,000 of indebtedness from which they were released. This new note was to be repaid by annual payments of principal of $I75,000 plus interest as provided therein.

As consideration for petitioner's assistance in the rearrangement of indebtedness with respect to the Arkansas and Togo Island tracts, Eubanks agreed to increase the sales price of those tracts by $106,500.

The proceeds of the $1,825,000 lent to Eubanks by Connecticut General secured by the first mortgages on the Togo Island, Arkansas, and Stewart tracts, and the Pickthorne lease were disbursed as follows:

Petitioners entered this transaction on their journal as follows:

Eubanks gave to petitioners a new note for $1,139,833.64 secured by mortgages on the Togo Island and Arkansas properties as well as the Stewart tract and the Pickthorne lease. These mortgages provided for payment to petitioners and to Connecticut General, the first mortgagee, of the proceeds of timber cut from the land. Petitioners on their tax returns for the years 1959 and 1960 treated the $397,000 payment made by Eubanks to Connecticut General by disbursement from the proceeds of his loan from Connecticut General to pay the mortgage which the Powe group had agreed to assume, as a refinancing of the purchase of the North Carolina tract; and when petitioners received the Powe group's first payment of $175,000 on the new note in 1960 (the payment due in 1959 having been extended to 1960), they reported the entire $175,000 on their tax return as a collection of principal on the North Carolina property instead of reporting only $156,000 of the $175,000 payment as a collection of principal on the North Carolina property.

Respondent in his notice of deficiency to petitioners considered the $397,000 as an additional payment on the Togo Island and Arkansas properties, computed as follows:

During the year 1960 Eubanks defaulted on the payment due petitioners on the $1,139,833.64 note secured by mortgages on the Togo Island, Arkansas, and Steward tracts and the Pickthorne lease and also on the note given upon the purchase of the Avoyelles Parish tract in 1959 which was secured by a mortgage on that tract. After the default, petitioners commenced foreclosure proceedings on all four of these properties.

The foreclosures with respect to all except the Louisiana portion of the Togo Island tract were completed in 1960. The foreclosure proceedings with respect to the Arkansas property resulted in the Chancery Court for the Lake District of Craighead County, Arkansas, entering a decree on July 12, 1960, reciting that of the note executed by Eubanks to petitioners in payment of certain lands conveyed to him by petitioners in the original amount of $1,139,833.64, there remained an unpaid principal balance of $1,063,098.01 with interest accrued to date of $57,724.24 and that if the sum together with an allowance of attorneys' fees of $5,000 with interest at 6 percent from the date of entry of the decree were not paid within 10 days, the Clerk of the Court for the Lake City District of Craighead County, Arkansas should advertise the property to be sold at public auction at the front door of the Courthouse. In the decree it was also noted by the Court that the note for $1,139,833.64 also covered and affected land in the States of Mississippi and Louisiana, which were not included in the Court's decree, the decree of the Court only covering the Arkansas land. The sale provided for in the order of July 12, 1960, was held on August 27, 1960.

Under date of September 7, 1960, petitioners received a Commissioner's Deed to all the Arkansas lands which were the subject of the mortgage guaranteeing the payment of the Eubanks' note. This deed confirmed the sale to petitioners of all these lands for the sum of $100,000 subject to the prior lien of Connecticut General. This deed recited that the bid by petitioners of $100,000 was the highest bid received upon the offering of the property for sale at public auction in accordance with the decree and that this sale had been approved by the Chancery Court.

Under date of August 5, 1960, petitioner received a Trustee's Deed to the Claiborne County, Mississippi land which he had purchased at the trustee's sale on August 5, 1960, which sale was in foreclosure of the deed of trust from Eubanks to secure his note to petitioners in the amount of $1,139,833.64. The deed recited that the highest bid for the property was in the amount of $10,000 by petitioners and also recited that the deed was subject to the outstanding mortgage which Connecticut General held on this property.

Under date of November 2, 1960, petitioners received a Sheriff's Deed to the Avoyelles Parish, Louisiana property which recited that after this property had been exposed to public sale according to law petitioners became the purchasers thereof for the sum of $400,000. Attached to the Sheriff's Deed was an appraisal by an appraiser appointed by the Sheriff which valued the property at $575,000. The Sheriff's sale was made in accordance with an order of the Twelfth Judicial District Court, Parish of Avoyelles, State of Louisiana which recited that Eubanks' indebtedness to petitioners secured by a mortgage on this property was in the amount of $1,175,000. The decree was entered with respect to a petition filed by petitioners on September 1, 1960, which petition recited various demands made by petitioners upon Eubanks prior to the date of the filing of the petition as well as payment by petitioners of taxes on the property which petitioners recited. Eubanks failed to pay and further recited that payments due January 15, 1960, and thereafter on the note had not been made. The terms of the sale of the Avoyelles Parish property as shown in the Sheriff's Notice of Sale, were "Cash, with benefit of appraisement, subject to that certain mortgage" which petitioner had given on December 1, 1955 to Mortgage Investment Corp. in the original amount of $275,000. The Mortgage Certificate prepared by the Deputy Clerk of the Court on search of the mortgage records of Avoyelles Parish, Louisiana, showed that there remained due on this mortgage the sum of $t75,000 on November 2, 1960, the date of the foreclosure sale.

Foreclosure proceedings were commenced by petitioners with respect to the Louisiana portion of the Togo Island tract during 1960, but were not completed until July 15, 1961, when petitioners bid the property in at a foreclosure sale for $121,000. The Louisiana portion of the Togo Island tract consists of approximately 6,100 acres.

In 1961 petitioners conveyed the Arkansas property including the Stewart tract and Pickthorne lease back to Eubanks for a total stated price of $2,850,000, but the property was repossessed within a 12 month period.

Petitioners on their 1960 income tax return reported no gain on the repossession of the Togo Island (Claiborne County, Mississippi), Arkansas, and Avoyelles Parish properties. Respondent in his notice of deficiency determined that petitioners had a gain on the repossession of these properties in a total amount of $445,411.14 consisting of a gain of $229,242.56 on the Togo Island and Arkansas properties and $216,168.58 on the Avoyelles Parish, Louisiana property. Respondent computed the gain on the Togo Island, Arkansas and
Avoyelles Parish properties, as follows:

In connection with the foreclosure of the Arkansas properties and the Mississippi portion of Togo Island, petitioners were required to make payments which Eubanks had failed to make on January 15, 1960, on the first mortgage due to Connecticut General, the total amount of this payment being $128,787.15. It consisted of principal due on January 15, 1960, of $77,401.79, interest due of $48,419.08 and $2,966.28 of expenses which Connecticut General had paid for Eubanks. This payment was made on August 2, 1960, after the filing of petitioner's complaint in the Chancery Court for the Lake City District of Craighead County, Arkansas, and the entry of that Court's decree that unless Eubanks' indebtedness to petitioners was paid within 10 days, the property would be sold at public auction, but prior to the sale of the Arkansas property to petitioners on August 27, 1960, or the sale of the Mississippi property to petitioners on August 5, 1960.

Petitioners deducted the $48,419.08 as interest paid and the $2,966.28 of expenses. Respondent in his notice of deficiency disallowed the claim deductions with the explanation that the $2,966.28 was nondeductible but an addition to basis of property, and the $48,419.08 amount represented interest "on another taxpayer's indebtedness and is not deductible in your return; rather such amount, which was another item included in the above-mentioned check to Connecticut General Life Insurance Company for $128,787.15, * * * is to be given consideration as a part of foreclosure cost."

Section 611 (a) of the Internal Revenue Code of 1954⁴ provides that in the case of timber, there shall be allowed as a deduction in computing taxable income a reasonable allowance for depletion. Respondent's regulations, section 1.611-1(a), provide that in the case of standing timber the depletion allowance shall be computed solely upon the adjusted basis of the property, and section 1.611-1 (b) provides that annual depletion deductions are allowed only to the owner of an economic interest in standing timber, defining an economic interest to be the interest possessed in every case in which the taxpayer has acquired by investment any interest in standing timber and secures by any form of legal relationship income derived from the severance of the timber to which he must look for a return of his capital. This regulation further provides that no depletion deduction shall be allowed the owner with respect to any timber that he has disposed of under any form of contract by virtue of which he retains an economic interest in such timber, if such disposal is considered a sale of timber under section 631 (b) or 631 (c). Section 631(b) provides that in the case Of the disposal of timber held for 6 months before such disposal under a contract by virtue of which the owner retains an economic interest in such timber, the difference between the amount realized from the disposal of such timber and the adjusted depletion basis thereof, shall be considered as though it were a gain or loss, as the case may be, on the sale of such timber. The date of disposal of such timber shall be deemed to be the date the timber is cut except at the election of the taxpayer where payment is made prior to the cutting of the timber.

Under either of these sections, and the facts are not sufficient to show with any clarity which would be applicable to petitioner with respect to the cutting which took place in 1955, the recovery of costs is by way of a depletion allowance or a completed sale of the timber at the date it is cut or paid for with the depletion basis considered as the cost of the timber sold. The allowable deduction in either event is for the timber as it is removed. The contracts here show that petitioner was to be paid from the timber as severed and that petitioner did have a capital investment in the timber. The yearly depletion allowance is based on the timber severed in each year and petitioner has shown no facts to show that respondent's computation of yearly depletion allowances in the instant case is not correct or any reason why receipts received from the sale of the timber should not be reported in the year received and the depletion applicable to such timber deducted in that year.

Petitioners argue that the timber cutting contracts were speculative with respect to receipts and petitioners had no gain or loss until the final completion of the contract, citing Morton Liftin, 36 T. C. 909 (1961), Aff’d 317 F. 2d 234 (C. A. 4, 1963) and Estate o[ Clarence W. Ennis, 23 T. C. 799 (!955). In the Morton Liftin case we held that a taxpayer who purchased speculative monthly payment notes at a discount was not required to report a pro rata portion of each payment of principal as income but did not realize taxable income until his basis in the notes had been recovered. In Estate o[ Clarence W. Ennis, supra, we held that a highly speculative agreement to pay did not constitute payment in property to a cash basis taxpayer but that such a taxpayer did not have reportable income from the sale which was the subject of the payment agreement until actual payments had been made in excess of his basis. This type of case has no relevance to sales of timber as cut under timber cutting contracts with a retained interest. Under such contracts the seller is entitled to recover his basis in the timber through a depletion deduction or an allocated portion of his depletion basis as the timber is severed.

Petitioner has failed to show any facts which show error in respondent's determination that depletion is the method for recovery of his basis in this timber. We sustain respondent in his determination in this regard,

Petitioners take the position that all of the $73,247.34 interest which they deducted on their 1956 income tax return is a business expense deduction and not a personal expense, and therefore they are entitled to that deduction as Well as the $1,000 standard deduction. Petitioners rely' on James J. Standing, 28 T. C. 789 (1957), Aff’d. 259 F. 2d 450 (C. A. 4, 1958), and Frank Polk, 31 T. C. 412 (1958), Aff’d. 276 F. 2d 601 (C. A. 10, 1960). In James J. Standing, supra, we held that interest accrued in 1951 by a taxpayer reporting his income on an accrual basis, on deficiencies for the taxable years 1945 through 1949, which deficiencies arose from adjustments of business income, was deductible as a business expense. In so holding, we stated at page 795 that the taxpayers "had a trivial amount of personal income not derived from the businesses but we have pointed out in our Findings of Fact that the asserted deficiency was based on adjustments of business income." In Frank Polk, supra, in determining that interest paid on an income tax deficiency arising from a prior year was properly deductible as a business expense in computing a net operating loss carryover we followed our holding in James J. Standing, supra. In the Frank Polk case, the deficiency with respect to Which the interest was paid arose from a reevaluation of the taxpayer's livestock inventory and the facts showed that during all of the periods pertinent in that case the taxpayers were engaged in the business of raising livestock. In the Frank Polk case, we distinguished Guignard Maxcy, 26 T. C. 526 (1956), in which we held that interest accrued and paid on deficiencies in personal income tax was not deductible as a business expense from gross income for the purpose of computing a net operating loss pointing out that in Guignard Maxcy, supra, we had found that the taxpayer had failed to carry his burden of showing that the interest payment was with respect to his business. In our opinion in Guignard Maxcy, supra, we stated that file interest expense accrued entirely on the taxpayer's personal income tax obligation which he did not pay when due.

While respondent argues that our holdings in the James J. Standing and Frank Polk cases are legally incorrect, he, in addition, points out that in the instant case petitioners have failed to show that the adjustments to income from which the deficiencies with respect to which the interest was paid arose were not entirely with respect to personal income or at least with respect to personal income to such an extent that over $1,000 of the interest paid would be with respect to deficiencies from adjustments of personal and not business income.

We agree with respondent that petitioners have totally failed to show what adjustments caused the deficiencies with respect to which the interest was paid and therefore in this case, as in Guignard Maxcy, supra, petitioners have failed to sustain their burden of proof. We therefore sustain respondent in h