On April 9, 2020, the Tax Court issued a Memorandum Opinion in the case of Littlejohn v. Commissioner (T.C. Memo. 2020-42). The issues properly before the court in Littlejohn v. Commissioner were whether (1) the petitioners are entitled to certain rental real estate deductions for the tax years at issue; (2) whether the petitioners are entitled to theft loss deductions for their tax years 2010 and 2013; and (3) whether the petitioners are liable for the IRC § 6662(a) accuracy-related penalty for each tax year at issue.
Background to Littlejohn v. Commissioner
It is never a good sign for the petitioner when the Tax Court begins its finding of facts with the observation that not only does petitioner-husband a law degree, but also that the petitioner-husband previously taught law at the Southern California Institute of Law in Santa Barbara. It is likely that the professor did not teach tax law, as the Tax Court would never have buried that lead.
Petitioner-wife, a budding real estate maven, owned two modest properties in Lompoc, California, a triplex and a single-family home that petitioners’ son purchased in 1996 and later deeded over to his mother. Petitioner-husband “manages” the properties. Desiring another small residence to her portfolio, the petitioners decided that she should purchase a chateau (valued two years earlier at $3.6m) and further decided the petitioner-wife should purchase it as her separate property. (Remember, California is a community property state.)
Despite multiple glaring defects to the property, which can be described best by the word “leaky,” The petitioner-wife purchased the property “as is” for $2.5m in June 2006. The petitioner-husband was not involved in the sale. Upon moving into the property, the water that the petitioners wanted to keep out of the house (rain) and the water that the petitioners wanted to come in (well water) did not flow all too well.
Due to the leaks in the garage’s roof, the ceiling collapsed just after Christmas in 2007. The petitioners filed a claim with their homeowner’s insurance carrier, who took two months to respond with a denial of the claim on the basis that the home was in dilapidated condition when the petitioner-wife bought the property, and she should have known what she was getting herself into buying a house “as-is” all the while being “represented” by the same real estate agent/broker that worked for the sellers.
The petitioners sued everyone they could think of including the contractor who was supposed to fix the leaks and other issues that they continued to discover about the property. Next, they sued the sellers of the property for false statements made on the seller’s disclosure form, and for actively trying to conceal the issues with the property. The contractor did not respond to the California Superior Court complaint, and the petitioner-wife was awarded a default judgment in the amount of $150,000. The petitioner-wife settled all claims eventually for a combined sum or $200,000.
Income Tax Return Preparation
Having filed all returns during the years in issue timely, the petitioners filed a Form 1040X (Amended Individual Tax Return) in August 2013. Their tax return preparer, Frank, was a CPA and licensed attorney specializing in tax matters. Frank relied on worksheets submitted by the petitioner-husband, and he did not receive supporting documents or otherwise independently verify the figures.
The 2010 and 2013 “Fraud Losses”
The petitioners’ 2010 Form 1040 included a Form 4684 (Casualties and Thefts), which reported a “fraud loss” attributable to the “non-recoverable” judgment against the contractor. The Form 4686 lists the basis of the property as $150,000 (the judgment), a FMV before the loss of $255,000 (the Tax Court opinion notes that the record did not reveal where the hell the petitioners came up with this number), and a FMV of the property after the loss of zero.
The petitioners’ 2013 Form 1040 claims a “FRAUD/CASUALTY LOSS” with an adjusted basis of the property as $1.2m (which was the actual basis of the home less the “2010 loss,” attorneys’ fees, expert witness fees, repairs, moving expenses, etc.), a FMV before the loss of $1.2m, and an FMV of the property after the loss of zero. Intrigued by this novel application of the casualty and theft loss provisions of IRC § 165, the IRS examined the petitioners returns, and determined that the “fraud loss” deductions for 2010 and 2013, like the petitioners’ erstwhile home, didn’t hold any water. Because of the “creativity” of the petitioners, accuracy related penalties were proposed under IRC § 6662(a) for negligence/disregard of rules or regulations and a substantial understatement of income tax.
Schedule E Deductions, Generally
IRC § 162 allows a deduction for ordinary and necessary business expenses. In addition, IRC § 212(2) allows a deduction for ordinary and necessary expenses paid or incurred for the management, conservation, or maintenance of property held for the production of income. See Grant v. Commissioner, 84 T.C. 809, 825 (1985), aff’d without published opinion, 800 F.2d 260 (4th Cir. 1986); see also Treas. Reg. § 1.212-1(h). The taxpayer bears the burden of proving entitlement to any claimed deduction. Tax Court Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). This burden requires the taxpayer to substantiate deductions by keeping and producing adequate records. IRC § 6001; Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); Meneguzzo v. Commissioner, 43 T.C. 824, 831-832 (1965); Treas. Reg. § 1.6001-1(a); Treas. Reg. § 1.6001-1(e).
Theft Loss
A deduction may be taken against ordinary income for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” IRC § 165(a). In the case of a loss by theft, a taxpayer may deduct the lesser of the fair market value of the stolen property; or the adjusted basis as determined under IRC § 1011. IRC § 165(b); Treas. Reg. § 1.165-7(b)(1); Treas. Reg. § 1.165-8(c).
A theft loss is “sustained during the taxable year in which the taxpayer discovers such loss.” IRC § 165(e). If there exists a claim for reimbursement in the year of discovery, however, no loss shall be considered sustained until the taxable year in which it can be ascertained with reasonable certainty that no reimbursement will be received. Treas. Reg. § 1.165-1(d)(3). Whether a reasonable prospect of recovery exists is a question of fact to be determined upon an examination of all facts and circumstances. Treas. Reg. § 1.165-1(d)(2)(i).
A reasonable prospect of recovery exists when the taxpayer has bona fide claims for recoupment from third parties or otherwise, and when there is a substantial possibility that such claims will be decided in his favor. Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 811 (1974), aff’d, 521 F.2d 786 (4th Cir. 1975). Whether there is a reasonable prospect of recovery is determined based primarily on objective factors. Id.; see Jeppsen v. Commissioner, 128 F.3d 1410, 1418 (10th Cir. 1997), aff’g T.C. Memo. 1995-342. Although the taxpayer’s subjective beliefs may also be considered, such subjective beliefs may not for the primary, sole, controlling criterion. Id.
The term “theft” (as used in IRC § 165) has a broad connotation, intended to cover any criminal appropriation of another’s property, including theft by larceny, embezzlement, obtaining money by false pretenses, and any other form of guile. Bellis v. Commissioner, 61 T.C. 354, 357, aff’d, 540 F.2d 448 (9th Cir. 1976); Treas. Reg. § 1.165-8(d). Generally, whether a theft loss has been sustained depends upon the law of the State where the loss was purportedly sustained. See Norton v. Commissioner, 333 F.2d 1005, 1008 (9th Cir. 1964), aff’g 40 T.C. 500 (1963).
Petitioners bear the burden of proving by a preponderance of the evidence that a theft actually occurred. See Tax Court Rule 142(a); Jones v. Commissioner, 24 T.C. 525, 527 (1955). To carry this burden of proof, petitioners must establish the existence of a theft within the meaning of IRC § 165, the amount of the claimed theft loss, and the year in which the theft loss was discovered. See Elliott v. Commissioner, 40 T.C. 304 (1963); River City Ranches No. 1 Ltd. v. Commissioner, T.C. Memo. 2003-150, aff’d in part, rev’d in part on other grounds, 401 F.3d 1136 (9th Cir. 2005).
Fraudulent Inducement not Theft
The petitioners claim that they are entitled to theft loss deductions because they were defrauded in the purchase of the leaky property. Such a cause of action does not exist in California (where the property is located) or at the national level. The few cases in which this Court has allowed theft loss deductions involving real estate transactions have involved contractors who took money from taxpayers under false pretenses and then either absconded or ceased construction and used the money for purposes not related to the construction agreement. See, e.g., Norton v. Commissioner, 40 T.C. 500; Miller v. Commissioner, 19 T.C. 1046 (1953); Urtis v. Commissioner, T.C. Memo. 2013-66; Hartley v. Commissioner, T.C. Memo. 1977-317. This is not such a case.
The Tax Court notes that the sellers’ warnings about the leaky garage and certain window defects were noted in the disclosure statement as potentially significant issues, which were confirmed and amplified by the petitioners’ own professional home inspection. Finally, the petitioner-wife bargained for the defects. The listed price was $3.6m. The actual sales price was $2.5m for the property, leaks, fogged windows, and general disrepair built into the reduced price.
Bright Line Rules
Caveat emptor – buyer beware! An owner of property may not claim a loss solely on the basis that they thought they were buying a more valuable (and less porous) asset than what they ultimately discovery that they bought. There is no provision in IRC § 165 or otherwise that permits a deduction for the monetary end-result of being an unsophisticated buyer, who relies on representations by the sellers of the condition of the seller and later cries foul.
(T.C. Memo. 2020-42) Littlejohn v. Commissioner
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