This article covers recent developments in individual taxation – Part 2. The items are arranged in Code section order.
Sec. 170: Charitable, Etc., Contributions and Gifts
A landfill operator tried to claim a charitable deduction for dirt it sold at a bargain price to the city of Tucson, Ariz., for use in closing another operator’s noxious-smelling landfill.  Although the settlement agreement between the taxpayer and Tucson qualified as a contemporaneous written acknowledgment under Sec. 170(f)(8)(A), it failed to contain a good-faith estimate of the values of the goods and services received by the taxpayer. The court also accepted the IRS’s challenge to the taxpayer’s valuation of the provided dirt.
In Estate of Harvey Evenchik,  the Tax Court continued to make clear its lack of patience with sloppy, poorly prepared appraisals of donated property. In this case, the taxpayer donated approximately 72% of his shares in a corporation that owned two apartment buildings to a nonprofit housing corporation. However, the attached appraisal valued the apartment buildings themselves, not the capital stock donated. It also failed to account for the fact that only a partial interest was donated. The court noted that “the appraisals had gaping holes of required information” as well.
In Villareale,  the taxpayer was denied deduction of cash contributions that exceeded $250 each to a ferret rescue organization that she co-founded, served as president, and managed the finances for. The organization did not issue the required contemporaneous written acknowledgments for those contributions. The taxpayer acknowledged this failure but argued that it would have been “futile to issue herself a statement.” She was allowed to deduct a series of donations of less than $250 each.
In Minnick,  the taxpayers’ agreement for a donated conservation easement falsely stated there was no existing mortgage on the property donated and contained a provision allowing for amending the terms of the agreement. This cost the taxpayers more than $180,000 in additional tax plus a 20% accuracy-related penalty. However, the Tax Court refused the IRS’s request to double the penalty to 40%. The taxpayers failed to have the bank execute a subordination agreement until nearly two years after the IRS issued the notice of deficiency and five years after the original donation was made. Their claim that the bank would have been willing to do so at any time was rejected by the Court, since the taxpayers had been required to pay down a portion of the mortgage to obtain the bank’s agreement. The Court stated: “intention and willingness are not what matters”
In Crimi,  the Tax Court handed the taxpayers a rare victory in a case where the qualified appraisal and documentation requirements of Sec. 170(f)(11) and associated regulations were not precisely followed. In July 2004, the taxpayers transferred 65 acres of undeveloped land to Morris County, N.J., in exchange for $1,550,000. Based on a 2000 appraisal, the taxpayers claimed the land was valued at $2,950,000 and claimed a charitable contribution of $1,400,000. The IRS denied the deduction based on three arguments: First, it found that the contemporaneous written acknowledgment was faulty because it was not signed by a county official, incorrectly described the property, and did not state whether the donee provided any goods or services to the donors. The Court disagreed, stating that the town official who signed acted as an agent for the county (as allowed under Rev. Rul. 2002-6730), that a small typographical error in the description did not prevent the IRS from identifying the exact parcel donated, and that the letter did state that a payment of $1,550,000 had been made to the donors in exchange for the property, precluding the need for any further “goods or services” language. Second, the IRS claimed that the highest and best use of the land was conservation, with a maximum fair market value of $660,000, far below the consideration received by the taxpayer. The Court, based on expert testimony (two experts each for the taxpayer and the IRS), concluded that the property’s fair market value on the date of contribution was nearly $2,966,000. Finally, the IRS argued that the appraisal from 2000 was not qualified because it failed to meet the requirements of Regs. Sec. 1.170A-13(c)(3). However, the taxpayers argued—and the court agreed—that they were entitled to reasonable-cause relief under Sec. 170(f)(11)(A)(ii)(II) because the taxpayers had reasonably and in good faith depended on the advice and opinion of their CPA of more than 24 years that the 2000 appraisal satisfied the requirement to attach a qualified appraisal to the return.
Sec. 183: Activities Not Engaged in for Profit
A horse-breeding case, Dodds,  illustrates several important considerations regarding the hobby loss limitation. The taxpayer owned a successful accounting firm, worked 70 to 80 hours a week during filing season, and earned a substantial six-figure income from his practice. He also started breeding horses in 1995. From then until 2003, he generated zero gross income from the horse-breeding activity and between 1995 and 2011 racked up cumulative net losses of nearly $1.5 million. The Tax Court’s decision against him (which involved only 2007 and 2008) was based on the nine-factor analysis under Regs. Sec. 1.183-2(b) of whether an activity is engaged in for profit. Weighing against a profit motive were the taxpayer’s unbusinesslike manner of carrying on the activity, his lack of success in similar activities, his history of losses, his lack of even occasional profits, and his financial status. Interestingly, the Court found the “elements of personal pleasure” factor neutral, despite its acceptance of his testimony that neither he nor his family ever rode the horses and that he spent more than 1,500 hours each year doing the “dirty work,” such as mucking stalls, feeding the horses, and administering medicine. The Court reasoned that to have poured all that money into the activity over the years, the taxpayer must have been getting some satisfaction from it. The Court’s critique of the taxpayer’s business practices in carrying on his horse breeding is worth noting. The Court faulted the taxpayer for not maintaining a separate bank account for the activity, although he did maintain separate financial records for it. Also, the Court stated that the taxpayer’s lack of a business plan with “more than just generalized goals” showed a lack of effort to reduce his losses. This was despite the fact that, based on expert advice, he changed his mode of breeding in 2004 and that he developed and patented a device to cut down on feed waste. Key takeaways: Always open a separate business bank account and maintain an updated, specific business plan.
Sec. 212: Expenses for Production of Income
In Heinbockel,  married taxpayers were engaged in several lines of businesses that included the husband’s one-airplane transport company and the couple’s purported residential rental business and grape farming operations. The air transport company never became profitable due to a lack of sources of revenue. The taxpayers reported losses from this activity totaling about $210,000 for tax years 2005 through 2007 on Schedule C.
As for the purported residential rental activity, the wife gave her brother a loan to purchase and manage real property, for which he would pay her interest and/or rent. When the loan fell through, the couple reported the loss from the loan on a Schedule E, Supplemental Income and Loss, for 2005. Other deductions on Schedule E included legal fees related to the loan. Meanwhile, the grape farming venture was also entangled with lawsuits and did not generate any income, so the taxpayers reported net losses of about $49,000 for 2005, $13,000 for 2006, and $8,000 for 2007 on Schedule F, Profit or Loss From Farming. The IRS issued notices of deficiency disallowing the losses from the three activities. The taxpayers challenged the IRS’s determination in Tax Court. The Tax Court found that the taxpayers lacked a profit motive in the air transport activity, and they never got beyond the startup phase of grape farming; hence, they were unable to claim any losses or deductions for those activities. The Court also found that the taxpayers did not conduct a lending business, because the taxpayers failed to show that they treated the wife’s lending activities like a business. However, the Court allowed the taxpayers to take a capital loss (subject to the Sec. 1211 $3,000 limitation) related to the activity and to deduct some of the legal fees as miscellaneous itemized deductions subject to the 2%-of-AGI floor.
Sec. 213: Medical, Dental, Etc., Expenses
In Longino,  the taxpayer claimed medical and dental expenses for 2006 that at trial he asserted totaled $11,949. He also claimed dependency exemptions for four children, three of whom did not reside with him and for whom he did not file Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, or a substitute. He also claimed deductions for ordinary and necessary business expenses of his law practice, charitable contributions, and tuition and fees. The taxpayer failed to provide substantiation for the deducted expenses. He was able to furnish evidence for $7,207 of the claimed medical and dental expenses. Included in that amount, however, was $4,421 for an in-vitro fertilization procedure for his former fiancée. Since she was an unrelated person and the taxpayer failed to prove that he had difficulty conceiving children, the court found that he was ineligible to claim the expense. The documentation submitted for the remaining $2,786 of claimed medical and dental expenses did not clearly indicate all were paid to health care service providers for qualifying medical care, so the court did not allow deductions for these expenses.
The Court also disallowed the dependency exemptions for three children, most of the claimed business expenses, and all the claimed charitable contributions and tuition and fees deductions. In addition, the Court held that the taxpayer was negligent in preparing his 2006 tax return, as he did not demonstrate reasonable care.
Sec. 215: Alimony, Etc., Payments
In Schuller,  the Tax Court disallowed the alimony deduction claimed by the taxpayer, a former member of the Air Force, for payments to his former spouse made by the Defense Finance and Accounting Service (DFAS). The taxpayer and his wife divorced in 1994, but the taxpayer did not attend the county court hearing for the divorce settlement, and the county court consequently awarded 60% of his Air Force retirement pay to his former wife as her sole and separate property. In 1998, the DFAS began distributing 50% of the taxpayer’s retirement to the taxpayer and the remaining 50% to the former spouse. In 2007 and 2008, both parties each received $15,384 and $15,738 in those respective years. The taxpayer then claimed $15,384 and $15,738 as alimony deductions on his 2007 and 2008 returns; however, the court disallowed these deductions.
Sec. 215(a) allows for a deduction of money paid for alimony if such payments meet the requirements of Sec. 71(b), including that they are made in cash. Transfers of property do not constitute cash paid for alimony purposes. The DFAS made payments directly to the taxpayer’s former spouse, and these payments were not owed by DFAS to the taxpayer or otherwise includible in his income. Consequently, the Court held that the taxpayer was not allowed to deduct the payments.
Sec. 280A: Business Use of Home
In Langley, married taxpayers in 2008 bought a single-family home, intending to remodel and sell it. They were unable to sell the property due to the downturn in the housing market, so they moved the taxpayer’s mother into the property. On their Schedule E they reported rental real estate expenses but did not report any rental income.
Under Secs. 280A(a), (b), and (d), a taxpayer cannot take deductions for expenses related to a dwelling unit that the taxpayer used as a residence. A taxpayer uses a dwelling unit as a residence if he or she uses it for “personal purposes” for more than the greater of 14 days or 10% of the number of days during the tax year that the unit is rented at a fair rental value. Personal use by the taxpayer includes uses by a member of the taxpayer’s family, including a parent. The Tax Court held that the taxpayers had not used the property as a rental property rather than a personal residence. They did not have a lease on the property, and the rent they said they charged, $600 per month, was well below the fair rental value of between $800 and $1,100 per month. Therefore, the court disallowed the Schedule E deductions the taxpayers claimed for the property. The IRS did allow mortgage interest and taxes on the property as itemized deductions on Schedule A, Itemized Deductions. Planning tip: A deduction for rental property expenses may be allowed in cases with a family member as a tenant if the taxpayer receives a fair market rent from the family member. Fair market rent can be established by rents charged for comparable rental properties.
Sec. 469: Passive Activity Losses and Credits Limited
In Hudzik,  the taxpayer claimed losses from rental real estate activities, asserting she qualified as a real estate professional. Her returns were self-prepared. She claimed she relied on the questions posed by TurboTax in concluding she qualified as a real estate professional. The Tax Court held that the taxpayer did not qualify as a real estate professional for the years in question, as she did not establish that she performed more than one-half of her personal services in real property trades or businesses. The Court did not find the taxpayer’s record of hours credible, considering that she had a full-time job in an unrelated occupation. The court therefore did not address whether she materially participated in the rental real estate activities either in total or individually. Because the Court held that the taxpayer was not a real estate professional, it disallowed her rental real estate losses to the extent that she did not qualify under the Sec. 469(i) exception allowing a maximum loss deduction of $25,000, subject to phaseout, for taxpayers that actively participate in rental real estate activities. The Tax Court also held that the taxpayer was liable for accuracy-related penalties because she had not acted in good faith, primarily because her recordkeeping appeared to have inflated the hours spent in rental real estate activities.
In Thomas,  the IRS did not adjust a taxpayer’s rental loss on its notice of deficiency to the taxpayer but at trial claimed that the taxpayer could not take the losses under Sec. 469. The taxpayer claimed that he was a real estate professional, so the losses were deductible. The Tax Court held that the taxpayer was a real estate professional because the IRS failed to prove otherwise. The Tax Court concurred with disallowing the deductions for some additional expenses related to the rental activities claimed on an amended return filed during the audit of the original return because the taxpayer failed to substantiate the additional expenses. Where the Tax Court found that adequate substantiation was provided, the deductions were allowed.
In Hoskins,  the Tax Court held that a couple did not materially participate in their rental real estate activities during 2006 and 2007 and therefore were not entitled to deduct losses exceeding the limitations imposed by Sec. 469. In addition, the Tax Court held that the taxpayers were not entitled to deductions for depreciation and other expenses related to certain real properties. Accuracy-related penalties were also upheld. The taxpayers owned properties in Florida and Ohio that were used as residential rentals or vacation rentals for periods of less than seven days, held for investment, or not completed for occupancy. The taxpayers included in their 2006 return an election to treat all interests in rental properties as a single activity. However, it was determined and agreed that some of the properties that were included were not actually rental real estate but were held for investment. Others were under construction and unavailable for occupancy. Still others had average periods of customer use of seven days or less, which is not considered a rental activity under Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A). The taxpayers did not present convincing evidence or contemporaneous records to show that they met any of the seven tests for material participation in Temp. Regs. Sec. 1.469-5T(a). Therefore, the court held that the taxpayers did not materially participate in their rental real estate activities. The court therefore did not need to decide whether one taxpayer’s activities as a licensed real estate agent qualified as a real property trade or business under Secs. 469(c)(7)(B) and (C). With respect to the real estate activities not grouped with rental real estate, the court did not find any differently than the IRS did with respect to material participation, for the same reasons as for the rental real estate. The Court further disallowed deductions for depreciation related to properties that were not ready for customer use because they had not been placed into service. It also did not allow deductions for expenses related to one property of which the taxpayers did not have legal ownership.
In Hassanipour,  the Tax Court held that the taxpayer failed to prove he spent more time on rental real estate activities than on his full-time job as a research associate and therefore did not qualify as a real estate professional. His records of his time spent on rental real estate activities did not appear to be contemporaneous. The court did not look at whether the taxpayer materially participated in the rental property activities, since it had concluded he did not qualify as a real estate professional. Thus, the Tax Court held that the taxpayer’s losses from rental real estate were limited under Sec. 469. The Tax Court held the taxpayer was liable for accuracy-related penalties because he did not show good faith or reasonable cause in his tax reporting positions. The court noted that he did not keep reliable records and that although he purportedly spent many hours studying the law and preparing his returns, he did not consult a tax adviser to assist him with the rules of Sec. 469, whose complexity he claimed should excuse the penalty.
Footnotes25 Boone Operations Co., LLC, T.C. Memo. 2013-101. 26 Estate of Harvey Evenchik, T.C. Memo. 2013-34. 27 Villareale, T.C. Memo. 2013-74. 28 Minnick, T.C. Memo. 2012-345. 29 Crimi, T.C. Memo. 2013-51. 30 Rev. Rul. 2002-67, 2002-2 C.B. 873. 31 Dodds, T.C. Memo. 2013-76. 32 Heinbockel, T.C. Memo. 2013-125. 33 Longino, T.C. Memo. 2013-80. 34 Schuller, T.C. Memo. 2012-347. 35 Langley, T.C. Memo. 2013-22. 36 Hudzik, T.C. Summ. 2013-4. 37 Thomas, T.C. Summ. 2013-5. 38 Hoskins, T.C. Memo. 2013-36. 39 Hassanipour, T.C. Memo. 2013-88.
Editor Notes: Karl Fava is a principal with Business Financial Consultants Inc. in Dearborn, Mich. Jonathan Horn is a sole practitioner specializing in taxation in New York City. Daniel Moore is with D.T. Moore & Co. LLC in Salem, Ohio. Susanne Morrow is a tax partner with EY in San Francisco. Annette Nellen is a professor in the Department of Accounting and Finance at San José State University in San José, Calif. Teri Newman is a partner with Plante & Moran PLLC in Chicago. Miguel Reyna is the sole owner of Reyna CPAs PLLC in Dallas. Kenneth Rubin is a partner with RubinBrown LLP in St. Louis. Amy Vega is a senior tax manager with Grant Thornton LLP in New York City. Donald Zidik is a manager with McGladrey LLP in Boston. Mr. Horn is chair and the other authors are members of the AICPA Individual Income Tax Technical Resource Panel. For more information about this article, contact Mr. Horn at firstname.lastname@example.org.
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