*159 Decision will be entered for the respondent.
Held: The proceeds from a forced sale of collateral by a creditor made in circumstances of the debtor's insolvency were properly applied by the creditor to unpaid principal on the indebtedness. Accordingly, where such proceeds were insufficient in amount to cover even the principal due on the secured obligation, the debtor was not entitled to any deduction for interest paid.
*784 The Commissioner determined an $ 8,097.87 deficiency in petitioners' income tax for the calendar year 1968. Petitioner George R. Newhouse had pledged certain shares of stock to secure certain indebtedness. The proceeds from the forced sale of those shares were insufficient to cover the full balance of Newhouse's*160 obligations, and the only issue for decision is whether the amounts realized from the foreclosure proceedings should have been applied first to accrued interest rather than principal, thus entitling Newhouse to deductions under section 163 of the 1954 Code.
FINDINGS OF FACT
The parties have filed a stipulation of facts which, together with accompanying exhibits, is incorporated herein by this reference.
Petitioners are husband and wife. They filed a joint Federal income tax return for 1968 with the district director of internal revenue at Los Angeles, Calif., and resided in that city when their petition herein was filed.
In 1962 George R. Newhouse (petitioner) joined with William M. Alberts, Robert E. Gibson, and Roy M. Good to purchase a controlling stock interest in a California corporation known as General Savings & Loan Association (General Savings). A substantial portion of the funds used to finance that purchase was advanced by the Sacramento, Calif., branch of the Wells Fargo Bank.
On August 29, 1963, petitioner and his associates obtained loans from First Western Bank & Trust Co. of Los Angeles ("First Western" or "the bank") in the aggregate amount of $ 2,231,709.06, and*161 used the proceeds to satisfy their aggregate indebtedness to the Wells Fargo Bank. The First Western loans were evidenced by individual promissory notes of each borrower in the following respective amounts:
| Petitioner | $ 1,038,533.77 |
| Alberts | 450,255.41 |
| Gibson | 450,255.41 |
| Good | 292,664.47 |
| 2,231,709.06 |
Concurrently with the making of the foregoing notes, petitioner and his associates jointly executed an instrument wherein they pledged, as collateral on their respective loans, certain individually held shares of stock in General Savings and two other California corporations. The pledge agreement authorized First Western to sell the collateral in "the event of the nonpayment of any part of the principal or interest under any of the said promissory notes * * *, or any extensions or renewals thereof, when due." The agreement did not direct the manner of apportionment of the proceeds from such a sale in the event *785 that those proceeds were insufficient in amount to cover both unpaid principal and accrued interest. Petitioner and First Western executed a bilateral amendment to the pledge agreement on or about October 25, 1963, the terms of which are not directly relevant*162 to the present controversy.
On or about December 16, 1963, petitioner and his associates borrowed additional funds from First Western amounting to $ 330,000 in the aggregate and represented by individual promissory notes of each borrower in the following respective amounts:
| Petitioner | $ 155,100 |
| Alberts | 66,000 |
| Gibson | 66,000 |
| Good | 42,900 |
| 330,000 |
The proceeds were used to purchase additional shares of General Savings stock. Pursuant to the terms of an amended and supplemental pledge agreement of December 11, 1963, both the newly purchased shares and the stock covered by the original pledge agreement of August 29, 1963, became collateral on the total indebtedness to First Western, and the rights and remedies of the parties in respect of that collateral were those set forth in the August 29, 1963, agreement.
The total principal on the two aforementioned notes executed individually by petitioner amounted to $ 1,193,633.77 ($ 1,038,533.77 plus $ 155,100). During the years 1963 through 1966 the notes were renewed from time to time, and petitioner made payments to First Western in respect thereof in the aggregate amount of $ 345,937.40. 1 The bank applied $ 198,415 of that*163 amount against principal, and it treated the remaining $ 147,522.40 1 as interest. There is no dispute that the bank made proper allocations of these items.
By June 24, 1966, the date of petitioner's last payment to First Western, he had thus reduced his aggregate indebtedness in respect of principal to $ 995,218.77. On or about June 30, 1966, he executed another note, promising to pay that sum with interest to First Western on "demand, or if no demand is made, then on September 28, 1966." Concurrently therewith, Mrs. Newhouse executed a "continuing guarantee" of her husband's indebtedness in favor of First Western. In that instrument*164 Mrs. Newhouse authorized the bank to apply the collateral on petitioner's indebtedness as it "in its discretion may determine."
*786 The value of petitioner's pledged stock then represented nearly the entire worth of all of his assets. The liquidation of certain of those securities was therefore necessary to provide funds to repay the First Western loan, and the bank thus authorized petitioner to arrange sales of certain of the pledged shares of General Savings stock on its behalf. The first such sale was made on August 4, 1966; 10 shares of General Savings were sold on that day for $ 630, and that amount was applied against interest due on petitioner's note. Thereafter, 100 shares were sold on August 11, 1966, for $ 6,300, and another 100 shares were sold on August 25, 1966, also for $ 6,300; the proceeds of both these sales were similarly applied against interest. No further sales were made prior to or on the due date of the note, September 28, 1966. The note was in default on September 28, 1966, and petitioner made no payments whatever thereafter with respect to his liability on the note, apart from the application of proceeds of sales of collateral to that liability. *165 After that date petitioner similarly arranged for four additional sales of General Savings stock held as collateral. Such sales were as follows:
| Date | Shares | Amount |
| Nov. 1, 1966 | 100 | $ 6,300 |
| Dec. 21, 1966 | 200 | 12,600 |
| Mar. 14, 1967 | 100 | 6,400 |
| Mar. 20, 1967 | 100 | 6,300 |
| 31,600 |
Unlike the application of the proceeds of the first three sales to interest, the proceeds of all four of these post-default sales were applied against principal. Such application to principal was made in accordance with an understanding between petitioner and an officer of the bank. The principal amount of petitioner's debt to First Western was thus reduced to $ 963,618.77. Petitioners claimed no deduction for interest paid to First Western on their joint return for 1967.
As already indicated, petitioner made no further payments in respect of his indebtedness to First Western. By a letter dated May 10, 1968, an agent of the bank notified petitioner that it planned to sell a large block of the remaining pledged securities, i.e., all of the shares of stock of one of the two corporations other than General Savings held as collateral for petitioner's note. The proposed sale was made on or*166 about July 2, 1968, for the net amount of $ 263,657.21. Having determined that the collectibility of the full balance owing in respect of principal was in grave doubt, the bank applied the proceeds of the July 2, 1968, sale against the principal on petitioner's note, as was its *787 usual practice in such circumstances. Upon receiving notice, in a letter of June 26, 1968, 2 of the manner in which First Western had treated the proceeds, petitioner complained to certain bank officials that the $ 263,657.21 should instead have been applied first to accrued interest. The bank, however, made no modification in its treatment of these amounts.
In a letter dated June 3, 1968, petitioner was notified of the bank's intention to sell all the remaining pledged securities. Certain of those securities (all *167 of the remaining General Savings stock) 3 were sold on or about September 11, 1968, for $ 227,477.97, which amount the bank also applied against principal. Although petitioner objected to the bank's sale of those securities, he made no objection to the application of the proceeds against principal; since he had been unsuccessful in his earlier effort to have the bank treat the proceeds of the July sale as interest rather than principal, he thought it would be futile to put forth a similar proposal in respect of the September sale.
As of September 11, 1968, First Western's ledger thus showed that $ 472,483.59 of principal remained unpaid. Notations made by the bank on the note disclosed that petitioner owed an additional*168 $ 140,289.90 of accrued interest as of August 16, 1968, plus $ 131.24 per day thereafter. By September 10, 1968, the accrued interest payable, pursuant to the bank's computations, amounted to $ 143,570.90, and petitioner's total indebtedness thus amounted to $ 616,054.49. On or about that date, First Western brought an action in the Los Angeles Superior Court against petitioner, Mrs. Newhouse, and two of petitioner's associates and their respective spouses. The bank alleged in its complaint that petitioner and Mrs. Newhouse had failed to make required payments under the terms of their note and guaranty, respectively, and prayed for damages in the aforementioned amount of $ 616,054.49 plus interest at 10 percent per annum from the date of the complaint.
The trial of the present case was held on June 27, 1972. Thereafter, on July 19, 1972, the parties to the State court action appeared in the California court and requested a conference in chambers with the court. Such conference was held but not reported. Then on the same day brief proceedings were held in open court where it appeared that *788 the parties had settled their differences. During the course of the proceedings*169 the court made the following comments:
Now, the Court has considered the discussions had with counsel in chambers concerning the law that applies to the performance of an obligation and the application of payments made thereon, and the Court is of the opinion that the bank should have applied the sums so obtained first to the interest then due, and that the cross-complainants Newhouse were reasonable in assuming that the proceeds had been so first applied to the payment of interest then due and the balance to the principal.
* * * *
In fact, Miss Clerk, I would ask that you make a minute order to this effect, if you please, that the counsel and the Court conferred in chambers for further settlement negotiations and, as a result thereof, the case was agreed to be settled with dismissals with prejudice to be filed by the plaintiff and by the cross-complainants.
On their joint return for 1968 the Newhouses claimed a $ 143,567 deduction for interest paid to First Western. The Commissioner disallowed that entire deduction.
OPINION
Petitioner has taken the position that First Western was required by law to apply the proceeds from the foreclosure sale of September 11, 1968 ($ 227,477.97), *170 first to accrued interest (approximately $ 143,570.90, by the bank's computations) and not to treat those proceeds, as it did, entirely as a recovery of overdue principal. The Commissioner maintains that the bank's actions were proper, and we think that his position must prevail.
To be sure, it is well established that a voluntary partial payment on indebtedness, made in ordinary course without any designation by the debtor as either principal or interest and in the absence of any agreement in this respect between debtor and creditor, is to be applied to interest before principal. See Story v. Livingston, 38 U.S. (13 Pet.) 359, 371; Motel Corp., 54 T.C. 1433">54 T.C. 1433, 1440; Estate of Paul M. Bowen, 2 T.C. 1">2 T.C. 1, 5, 7; cf. George S. Groves, 38 B.T.A. 727">38 B.T.A. 727, 737, limited in another respect by B. F. Edwards, 39 B.T.A. 735">39 B.T.A. 735, 738-739. However, that rule does not appear to be applicable in the case of an involuntary foreclosure of mortgaged property, particularly where the debtor is insolvent.
In John Hancock Mutual Life Ins. Co., 10 B.T.A. 736">10 B.T.A. 736,*171 a creditor foreclosed on mortgaged property and purchased that property itself at a price less than the outstanding principal on the underlying obligation. It was held that no portion of the purchase price was allocable *789 to accrued interest owing at the time of the foreclosure proceedings. Although the creditor in that case was a life insurance company which was taxed under special provisions of the statute, the term "interest" as used in such provisions was construed to have its "usual and ordinary meaning." 10 B.T.A. at 739. In similar circumstances, where a debtor conveyed mortgaged property to his creditor in order to avoid a foreclosure sale on that property and the fair market value thereof was less than the amount of unpaid principal, it has consistently been held that the creditor realized no interest income from the recovered property even if interest as well as principal was payable at the time of the conveyance. Helvering v. Missouri State Life Ins. Co., 78 F. 2d 778, 780 (C.A. 8); Manufacturers Life Insurance Co., 43 B.T.A. 867">43 B.T.A. 867, 873-874; 4 cf. Manhattan Mutual Life Insurance Co., 37 B.T.A. 1041">37 B.T.A. 1041, 1043-1044.*172 Thus, cases of this character are to be sharply distinguished from those involving voluntary partial payments. Nor is the result reached in such cases to be limited to life insurance companies, for, as indicated above, the meaning of the word "interest" as used in the life insurance provisions of the statute is the same as in other parts of the Code.
Estate of Paul M. Bowen, 2 T.C. 1">2 T.C. 1, relied upon by petitioner, is distinguishable. To be sure, that case holds that the "interest-first" rule may be applicable even to the proceeds of a foreclosure sale. But the Bowen Court carefully pointed out that the creditor had "arranged by voluntary agreement with" the debtor that the collateral should*173 be sold to repay the debt and "that the payments made were voluntary." 2 T.C. at 9. No such finding was made in the John Hancock case. And the conveyances in the other "life insurance" cases were "voluntary" only in the sense that the creditor acquiesced therein solely to avoid forced sales of the mortgaged properties. The September 11, 1968, foreclosure sale by First Western, in respect of which petitioner seeks to have the Bowen rule apply, was unquestionably involuntary on his part. At the trial herein, he emphasized that he had made plain his opposition to such a sale well before it took place.
Moreover, Bowen is further distinguishable on the ground that the Court there explicitly stated that there was "no evidence" that the taxpayer was "insolvent." 2 T.C. at 7. In the present case, on the other hand, the record strongly indicates that petitioner was insolvent. Petitioner's note was in default at maturity, on September 28, 1966, and beginning in November 1966, he agreed to the application of *790 the proceeds of certain sales of collateral to principal. He admitted at the trial that he did not have any*174 other assets of consequence at that time. Nor did he show that his financial condition improved between that time and the forced sale of the collateral here in issue in 1968. He made no payments whatever on his note after maturity (apart from the application of proceeds of sales of collateral), and the bank quite understandably treated the note as uncollectible apart from the collateral. Thus, the evidence shows that on March 9, 1967, it set up a reserve of $ 227,190 against the loan, that on July 2, 1968, it set up an additional reserve of $ 89,500 against the loan, and that finally, on September 17, 1968, it increased the reserve by an additional $ 155,793.59, thereby wiping out the entire asset on its books. Further, the evidence shows that for internal accounting purposes, the bank not only ceased to accrue any interest on the loan after December 12, 1966, but that on March 9, 1967, it retroactively reversed the accrual of unpaid interest (in the amount of $ 30,511.15) from June 30, 1966, to December 12, 1966. We have no doubt on the evidence before us that petitioner was insolvent at all relevant times in respect of the issue before us.
The significance of petitioner's insolvency*175 cannot be minimized. What would be deductible by him as interest would similarly be includable in the bank's income as interest received. And we find it difficult to believe that a creditor who was foreclosed on the collateral of an insolvent debtor, and who will never get back the full amount of his principal, is required to report a fictitious amount of income designated as interest." 5
Nor is any support for petitioner's position to be found in the statement by the Los*176 Angeles Superior Court during the course of the July 19, 1972, hearing, or otherwise in the law of California. We are required to give only "proper regard," and not necessarily to follow, decisions of local trial courts as to matters of local law. Cf. Commissioner v. Estate of Bosch, 387 U.S. 456">387 U.S. 456, 465. The trial judge's remarks, which were supported by no citation to authority and uttered after discussions in chambers of an undisclosed nature, but which obviously related to the settlement of the case between the parties, are hardly persuasive in the context of the issue before us. And petitioner's reliance *791 on section 1479 of the California Civil Code (West 1954) 6 is likewise misplaced. That section plainly does not govern the application of "involuntary" payments, particularly those arising out of a foreclosure sale not agreed to by the debtor. Ohio Electric Car Co. v. Le Sage, 198 Cal. 705">198 Cal. 705, 709, 247 Pac. 190, 192; Brunswick Corporation v. Hays, 16 Cal. App. 3d 134">16 Cal. App. 3d 134, 138-139, 93 Cal. Rptr. 635">93 Cal. Rptr. 635, 637-638 (2d Dist. Ct. App.).
*177 Decision will be entered for the respondent.
Footnotes
1. The figures are taken from a copy of First Western's loan liability ledger for petitioner's account. A separate exhibit, purporting to be a summary of the transactions shown on the ledger, reflects aggregate payments and interest in amounts different from those shown above. Both exhibits were stipulated to by the parties, and they have offered no explanation of these discrepancies.↩
2. Why the June 26 letter referred to the July 2 sale as if it had already taken place is not explained on the record. A possible explanation is that the June 26 letter was actually written and sent at a later time.↩
3. Although the bank also attempted to sell the securities in the third corporation held by it as collateral, it was unsuccessful in this respect. The record does not show that such securities were of substantial value in relation to the amount of petitioner's outstanding indebtedness to the bank.↩
4. A different situation exists where the amount of the creditor's bid on a foreclosure is equal to principal plus accrued interest, as noted in the Manufacturers Life Insurance Co. case, which thus distinguished Helvering v. Midland Insurance Co., 300 U.S. 216">300 U.S. 216↩.
5. A different result may be called for where the creditor unilaterally elects to treat the proceeds from a foreclosure sale as payments of interest rather than principal. See Kate Baker Sherman, 18 T.C. 746">18 T.C. 746, 753, questioned in another respect in Mozelle Rushing, 58 T.C. 996">58 T.C. 996, 1000↩. First Western applied the proceeds here in issue to principal, however, and we express no opinion as to the tax consequences attaching to such an exercise of discretion by a creditor in other circumstances.
6. Sec. 1479. Act of performance applicable to two or more obligations; application to specific obligation --
Where a debtor, under several obligations to another, does an act, by way of performance, in whole or in part, which is equally applicable to two or more of such obligations, such performance must be applied as follows:
One -- If, at the time of performance, the intention or desire of the debtor that such performance should be applied to the extinction of any particular obligation, be manifested to the creditor, it must be so applied.
Two -- If no such application be then made, the creditor, within a reasonable time after such performance, may apply it toward the extinction of any obligation, performance of which was due to him from the debtor at the time of such performance; except that if similar obligations were due to him both individually and as a trustee, he must, unless otherwise directed by the debtor, apply the performance to the extinction of all such obligations in equal proportion; and an application once made by the creditor cannot be rescinded without the consent of [the] debtor.
Three -- If neither party makes such application within the time prescribed herein, the performance must be applied to the extinction of obligations in the following order; and, if there be more than one obligation of a particular class, to the extinction of all in that class, ratably:
1. Of interest due at the time of the performance.
2. Of principal due at that time.
3. Of the obligation earliest in date of maturity.
4. Of an obligation not secured by a lien or collateral undertaking.
5. Of an obligation secured by a lien or collateral undertaking.↩