*926 1. A taxpayer, acting through a trustee, purchased land subject to a mortgage which he did not assume, and later had the trustee convey his interest in it by a quitclaim deed to the mortgagee's nominee without consideration. Held, the conveyance was not a sale or exchange and the resulting loss was not a capital loss.
2. Under a determination, assailed by the taxpayer, that his loss on the conveyance of mortgaged property to the mortgagee was a capital loss, the Board, in the absence of timely pleading, is not required to search the record to ascertain whether the taxpayer is relieved of other items than the mortgage liability, such as taxes or interest.
3. A portion of taxpayer's expenses was properly allocable to interest on tax-exempt securities. Held, such portion does not reduce the deduction for expenses. Sec. 24(a)(5), Revenue Act of 1934.
*970 The Commissioner determined a deficiency of $1,148.41 in income tax of petitioners for 1935, treating a loss on the conveyance of realty to a mortgagee*927 as a capital loss, and making an addition to the income of a trust distributable to a beneficiary.
FINDINGS OF FACT.
1. On April 27, 1926, the Chicago Title & Trust Co. executed a declaration of trust, designated trust No. 16580, in respect of certain real estate known as Ravinia Woodlands to which it was about to take title, agreeing to hold that and any other real estate deeded to it for the benefit of "any person or persons who may become entitled to any interest under this trust * * *." It was agreed:
that the interest of any beneficiary hereunder shall consist solely of a power of direction to deal with the title to said property and to manage and control said property as hereinafter provided, and the right to receive the proceeds from rentals and from mortgages, sales or other disposition of said premises, and that such right in the avails of said property shall be deemed to be personal property, and may be assigned and transferred as such; * * *
The trustee was not required to advance any money on account of the trust, and if it should do so, the beneficiaries were to repay it with interest; the trust agreement was not to be recorded, and the trustee "will deal with*928 said real estate only" on the written direction of the beneficiaries. On June 1, 1929, the Chicago Title & Trust Co., *971 as trustee, executed trust deeds on certain lots in Ravinia Woodlands to secure the payment of its promissory notes to the State Bank of Chicago, as follows:
| Lot No. | Amount of note |
| 2 | $5,000 |
| 3 | 5,000 |
| 16 | 4,250 |
| 17 | $5,000 |
| 18 | 4,000 |
| 21 | 4,750 |
Each of the notes provided, in part, that:
This note is * * * payable only out of the property specifically described in said Trust Deed securing the payment hereof * * *. No personal liability shall be asserted or be enforcible against the promissor or any person interested beneficially or otherwise in said property * * * in case of default * * * the sole remedy of the holder hereof * * * shall be by foreclosure of the said Trust Deed. * * *
The foregoing provision was also applicable to interest payments.
In December 1929, petitioner Warner G. Baird purchased from Baird & Warner, Inc., an Illinois corporation, the equitable interest in 13 of the lots in Ravinia Woodlands. Each of the lots was subject to a mortgage, and the amount payable by petitioner for his equitable*929 interests was the balance remaining after a deduction of the mortgage from a recited "price." This balance was paid by a charge against Baird's account with the vendor corporation, which had arisen from advances made by him to the corporation from time to time. The recited price of each lot, the amount of the mortgage thereon, and the balance charged to Baird's account were as follows:
| Lot No. | Price | Mortgage | Balance |
| 2 | $5,759.00 | $5,000 | $759.00 |
| 3 | 5,759.00 | 5,000 | 759.00 |
| 4 | 5,240.08 | 4,500 | 740.08 |
| 5 | |||
| 8 | |||
| 14 | 16,586.24 | None | 16,586.24 |
| 15 | |||
| 7 | 4,607.06 | 4,000 | 607.06 |
| 16 | $4,895.05 | $4,250 | $645.05 |
| 17 | 5,759.00 | 5,000 | 759.00 |
| 18 | 4,664.12 | 4,000 | 664.12 |
| 19 | 4,664.12 | 4,000 | 664.12 |
| 21 | 5,471.02 | 4,750 | 721.02 |
| Total | 63,404.69 | 40,500 | 22,904.69 |
On June 17, 1930, the trustee conveyed lots 2, 3, 4, 5, 7, 11, 16, 17, 18, 19, and 21, subject to encumbrances, to a nominee, who on the following day reconveyed them to the Chicago Title & Trust Co. as trustee, and it accepted the conveyance under a declaration of trust, designated trust No. 25207, similar in terms to trust No. 16580, and naming as beneficiary:
WARNER G. BAIRD, during his lifetime, with*930 full power to dispose of the entire beneficial interest herein, and in case of his death during the existence of this trust and while he continues to be the sole beneficiary hereunder, (his interest not having been previously assigned, transferred or divested either in whole or in part by any means or in any manner whatsoever), then and immediately thereupon JULIA DOLE BAIRD, if she shall be then living.
*972 In September 1930 and July 1931, Baird paid special assessments on some of the lots as follows:
| Lot No. 16 | $741.64 |
| Lot No. 17 | 846.31 |
| Lot No. 18 | 648.01 |
| Lot No. 21 | 365.43 |
On May 2, 1933, Baird executed a trust agreement, designated trust No. 30671, whereby he transferred to the trust company as trustee property consisting of securities and real estate, including lots 2, 3, 4, 7, 16, 17, 18, 19, and 21 in Ravinia Woodlands, to secure the payment of Baird's note for $391,000 to the trust company on May 2, 1935. The trustee was directed to apply the trust income to interest and thereafter to principal, and if the note should not be paid at maturity, to sell trust property and apply the proceeds to principal. Upon payment in full of the note, the*931 trustee was to reconvey all remaining trust property to Baird. The trust company waived "any claim for the payment of interest upon said indebtedness, except such as shall be due out of the income from said properties * * *." The trust instrument further provided that Baird:
shall have the management of the real estate which may at any time be held subject to the terms of this agreement, and shall have the charge of the renting and handling thereof, and be or his agents shall collect the rents, issues and profits thereof; and shall pay all the costs and expenses reasonably necessary for the protection, maintenance and operation thereof, including repairs, alterations, improvements, insurance premiums, interest or encumbrances and taxes (general and special).
On February 16, 1934, the trust company, as trustee under trust No. 25207, conveyed the nine lots to a nominee, who on the same date reconveyed the them to the trust company as trustee under trust No. 30671.
On December 17, 1935, the trust company, as trustee under trust No. 30671, conveyed lots 16, 17, 18, and 21 to a nominee of the First National Bank of Chicago, which held the mortgages on them. The mortgages were*932 canceled. On December 30, 1935, the trust company, as trustee under trust No. 30671, conveyed lots 2, 3, 4, 7, and 19 to another nominee. In receiving title to lots 2 and 3, she acted for Baird & Warner. The trust company received no consideration for these transfers, but made them at the direction of Baird under an arrangement whereby it took over certain trust assets on account of an unpaid balance of $376,000 on his note and conveyed out trust properties which its officers did not consider of value. There was a total of $11,000 unpaid taxes on the lots when the conveyances were made.
*973 Baird's ledger shows that lots 2 and 3 were conveyed to Baird & Warner in 1935 in consideration of the cancellation of mortgages, and that lots 16, 17, 18, and 21 were assigned to the nominee in consideration of the cancelation of mortgages. The ledger shows charges to profit and loss on the lots as follows:
| Lot No. | Charge |
| 2 | $759.00 |
| 3 | 759.00 |
| 16 | 1,386.69 |
| 17 | 1,605.31 |
| 18 | $1,312.13 |
| 21 | 1,086.45 |
| Total | 6,908.58 |
Petitioner deducted the $6,908.58 on their joint income tax return for 1935 as an ordinary loss.
2. The First National Bank of Chicago*933 was a cotrustee of a trust under the will of John N. Dole, of which petitioner Julia Dole Baird was a beneficiary. The will directed the trustees, in part, as follows:
(a) That they pay to the CONGREGATIONAL CHURCH of Limerick, Maine, Two HUNDRED ($200.00) DOLLARS each year for ten (10) consecutive years from and after my decease.
* * *
(c) Until the distribution of the principal of said trust fund, as hereinafter provided, the income therefrom shall be paid to my two daughters, JULIA DOLE BAIRD and JOSEPHINE DOLE BUTLER, or the survivor of them, giving, however, to the lawfull issue of any deceased daughter of mine the parent's share.
At the expiration of ten (10) years from and after my decease, the principal of said trust fund * * * shall be distributed to my said two daughters, or the survivor of them * * *.
The will also provided, in part:
I hereby authorize and empower my said Executors and Trustees to hold and retain as part of the trust estate, any property coming into their hands under the provisions of this Will, and to handle, manage and control my estate and sell, assign, convey, hypothecate, mortgage, encumber, pledge, lien, lease and transfer, in fee simple*934 or otherwise, with or without covenants and warranty, the whole or any part of the property, real, personal and mixed of which I may die seized or possessed, or to which I may be entitled at the time of my decease, at such time or times, in such manner, for such price and on such terms, as they may deem expedient * * *.
Pursuant to the terms of the will, the trustees paid $200 to the Congregational Church of Limerick, Maine, on September 2, 1935. Of this amount $133.63 was shown on the fiduciary return of the trust as paid out of taxable income. A capital gain of $1,084.72 was shown on the return as taxable to the trustees. The balance of the income of the trust, $27,634.56, was distributed equally between the two beneficiaries of the trust, and petitioners included on their return the share of Julia Dole Baird, $13,817.28, as income taxable *974 to them for 1935. Petitioners did not report as income taxable to them for 1935 any portion of $13,791.93 shown on the fiduciary return of the trust as income from nontaxable obligations, made up as follows:
| Interest on obligations of a state or political subdivision thereof | $1,462.66 |
| Interest on United States Treasury notes | 4,123.38 |
| Interest on United States Liberty and Treasury bonds | 8,205.89 |
| Total | 13,791.93 |
*935 The duties of the First National Bank of Chicago, as trustee, were the custody and possession of all securities, the collection and disbursement of income therefrom, the frequent analysis of securities from an investment standpoint, the making of recommendations to the cotrustees as to sales and reinvestment of securities, the collection of maturing obligations, the frequent and regular purchase, sale, investment, and reinvestment of trust property and securities, the preparation of tax returns, both Federal and local, the supervision and management of real estate, and consultation and communication with the cotrustees concerning general matters pertaining to the administration of the trust. The approximate market value of the securities in the trust in 1935 was between two and three million dollars.
The First National Bank of Chicago, for its services as trustee, was paid, after negotiations with the cotrustees, $4,926.90 in cash as fees, plus $57.77 for sundry expenses, on December 21, 1935. The fees were for the period from November 1, 1933, to November 30, 1935. The sundry expenses were as follows:
| Date | Description | Amount |
| February 6, 1935 | Insurance and postage on shipment of 500 shares of Standard Oil of Indiana stock | $0.32 |
| April 17, 1935 | 10% commission on collection of Villa Park bond interest | .60 |
| May 20, 1935 | 10% commission on collection of Villa Park bond interest | 42.30 |
| June 13, 1935 | Payment in connection with the proceeds of sale of 16 shares of common stock of Mission Corporation: | |
| Commission | 2.50 | |
| Tax | 1.13 | |
| Postage | .22 | |
| June 27, 1935 | Certified copy of decedent's will | 3.75 |
| August 12, 1935 | 10% commission on collection of Villa Park bond interest | 6.50 |
| September 26, 1935 | Photostatic copies of tax bills | .15 |
| October 21, 1935 | 10% commission on collection of Villa Park bond interest | .30 |
| Total | 57.77 |
*936 Included in the income received by the trust under the will of John N. Dole in 1935 was $321.46 interest on special assessment bonds of the city of Chicago and $689.30 interest on similar bonds of the village of Villa Park, Illinois. The bonds were issued to anticipate the collection of certain installments of specified special assessments. The bonds and the interest were payable solely out of such installments when collected.
*975 OPINION.
STERNHAGEN: 1. The petitioner deducted the cost, $6,908.58, of the lots in Ravinia Woodlands as an ordinary loss. This deduction the Commissioner disallowed, saying:
The examination indicated that Mr. Warner G. Baird purchased in December of 1929 six lots at a total cost of $34,908.58. These properties were subject to mortgages totaling $28,000, leaving a net equity of $6,908.58. In December of 1935 this real estate was quit-claimed by Mr. Baird to the mortgage holders. This is considered to be a capital transaction, coming within the provisions of section 117 of the Revenue Act of 1934, and the loss of $6,908.58 is being considered under item (f) herein.
As shown by the findings, the petitioner did not assume the mortgages*937 on the property and was not liable on them. His interest was only in the "equity." The threat of foreclosure of the mortgage was only ominous to him if the property was worth more than the mortgage. Apparently it was not. The quitclaim was not to relieve petitioner of a liability, but only to simplify the transfer of title. As to him it had no aspect of a sale or exchange. ; ; (on review C.C.A., 6th Cir.); (on review C.C.A., 5th cir.). The situation is unlike ; certiorari denied, ; rehearing denied, , in which the quitclaim deed was given in exchange for a release of the taxpayer's mortgage obligation.
In respondent's brief, after expressing disagreement with the decision in *938 , the suggestion is made for the first time that by giving the quitclaim the petitioner may have been relieved of liability for taxes or for mortgage interest or for other items. The petitioner had no reason to suppose that there was any issue except as to his liability for the mortgage and whether, on that account, his quitclaim was to be regarded as a sale or exchange. By the question which respondent now attempts to raise in his brief, the Board would be required to research the record for other items of liability and to determine whether by the quitclaim petitioner was relieved of such liability. This is a burden which the Board is not required to assume unless the matter has been the subject of the litigation. While the Government is not limited or bound by an inept or inadequate deficiency notice, there is ample opportunity, by timely pleadings, for the expansion of the issues of fact and law so that they can be fully explored and presented before the end of the trial. There is no reason for speculation, outside the stated issues, as to whether the petitioner was relieved of an existing liability for taxes or interest, and it is unfair*939 to surmise now that he was. From the record it appears more likely that *976 he had no such liability or that, if he had, he was not relieved of it.
The deficiency was incorrect in treating the loss of $6,908.58 as a capital loss.
2. The Commissioner increased the income attributable to Julia Dole Baird as the beneficiary of a trust established by her father's will. The deficiency notice does not clearly explain the determination and the Commissioner has several times shifted his position, so the issues are in some confusion.
(a) The respondent has conceded that the determination of the trust's taxable income erroneously includes interest on improvement bonds of the city of Chicago and of the village of Villa Park. Such interest is exempt. .
(b) At the hearing, the respondent stated that a reason why the expenses of the trust were not deductible was because the trust was not engaged in carrying on a trade or business but was only a passive recipient of income and a conservator of investments, citing *940 ; , affirming . There is nothing in the deficiency notice or the pleadings to suggest this question, and petitioner complains that he was unprepared at the trial to meet the new contention; although he urges that the evidence indicates frequent and regular transactions sufficient to constitute a business. The issue, we think, was not properly pleaded and it would be unfair to consider it. The deficiency proceeded upon the postulate generally that expenses were deductible by the trust, and held that it was necessary to apportion the expenses between taxable and nontaxable income. The petitioner assailed the requirement of apportionment.
Under Revenue Act of 1934, section 24(a)(5), 1 the deduction of expenses is limited so as to exclude from the deduction an amount allocable to tax-exempt income "other than interest." As shown by the findings, all of the trust's tax-exempt income was interest and, therefore, there is no part of the trust's expense deduction which is properly allocable to tax-exempt income other than interest*941 and no occasion for an apportionment. The entire amount of expenses of the trust is properly deductible, ; .
Decision will be entered under Rule 50.
Footnotes
1. SEC. 24. ITEMS NOT DEDUCTIBLE.
(a) GENERAL RULE. - In computing net income no deduction shall in any case be allowed in respect of -
* * *
(5) Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this title; or
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