On June 3, 2020, the Tax Court issued a Memorandum Opinion in the case of McCarthy v. Commissioner (T.C. Memo. 2020-74). The issues before the court in McCarthy were (1) whether the petitioner is entitled to deductions for qualified residence indebtedness with respect to real properties in New York and California, and (2) whether petitioner is liable for an accuracy-related penalty under IRC § 6662.
Brief Background on Residences of Petitioner
From about 1999 to 2003, the petitioner resided at the Hermosa Beach property and paid rent to a friend and fellow CPA. In 2005, the petitioner moved to New York City, New York. He later bought a co-op unit there and resided in it until 2014, when his job ended unexpectedly. He then moved to Minnesota.
Qualified Residence Interest – A Primer
Although the general rule IRC § 163(a) provides that a taxpayer may claim a deduction for interest paid or accrued on an indebtedness, the exception of “personal indebtedness” in IRC § 163(h) carves out a substantial chunk from this general rule.
A deduction is allowed, however, for “qualified residence interest” which includes “acquisition indebtedness” and “home equity indebtedness” with respect to any qualified residence. IRC § 163(h)(2)(D) (qualified residence interest); IRC § 163(h)(3)(A)(i) (acquisition indebtedness); IRC § 163(h)(3)(A)(ii) (home equity indebtedness). Acquisition indebtedness is defined as debt that is used to acquire, construct, or substantially improve a “qualified residence” and that is secured by that residence. IRC § 163(h)(3)(B)(i).
A qualified residence is the principal residence of a taxpayer, and one other residence selected by the taxpayer for purposes of claiming a qualified residence interest deduction which is used by the taxpayer as a residence (as defined by IRC § 280A(d)(1)). IRC § 163(h)(4)(A)(i). Neither the Code nor the regulations fix the time or manner by which a taxpayer makes a selection of the one “other residence” under IRC § 163(h)(4)(A)(i)(II). Accordingly, making the selection in litigation is acceptable. Dunford v. Commissioner, T.C. Memo. 2013-189; Lawler v. Commissioner, T.C. Memo. 1995-26.
Disqualifying the New York Property
Under IRC § 163(h)(4)(A)(i)(I) “principal residence” has the same meaning as under IRC § 121. However, Congress, in their infinite wisdom and foresight decided that they were just going to screw with us and lead us on a wild freaking goose chase, because IRC § 121 does not define the term “principal residence.”
Instead, we have to go to the Treasury Regulations to find something that approximates a definition. If a taxpayer alternates residency between two properties, the regulations tell us, then the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer’s principal residence. Treas. Reg. § 1.121-1(b)(2). Whether a taxpayer uses a property as his principal residence depends upon all the facts and circumstances. Treas. Reg. § 1.121-1(b)(1).
With regard to the NY Property, the petitioner did not reside at the property in 2015. Not ever. The Tax Court appears to extend an olive branch to the petitioner when it observes that the mere fact that a taxpayer rents out a property after moving out does not necessarily mean that the property has ceased to be the taxpayer’s principal residence. Thomas v. Commissioner, 92 T.C. 206, 241-242 (1989). But just as quickly, the olive branch becomes a switch and the Tax Court returns to swatting at the petitioner with words like “unconvinced” and “failed” “living with his parents in Minnesota.”
For purposes of IRC § 280A(d)(1), a dwelling unit is used by the taxpayer as a residence during the taxable year if the taxpayer uses it for personal purposes for more than the greater of (1) 14 days during the taxable year or (2) 10% of the number of days during the taxable year that the unit is rented at a fair rental value. Because petitioner rented out the New York City property for all 365 days in 2015, it was not used as his residence within the meaning of IRC § 280A(d)(1) and hence is not a qualified residence within the meaning of IRC § 163(h)(4)(A)(i)(II).
Disqualifying California Property
Petitioner testified that in 2010 he purchased from the fellow CPA, for $600,978, a 32.5% interest in the California property. He testified that he had his own separate entrance to the California property, his own bedroom and bathroom on a separate floor of the property, and the use of the common areas of the home. Ultimately, the Tax Court found that (1) the petitioner’s purported debt to his fellow CPA was not “secured debt” within the meaning of the relevant regulations so as to constitute acquisition indebtedness; (2) the petitioner has not shown that the California property was his qualified residence in 2015; and (3) the petitioner has not shown that as a cash basis taxpayer he actually paid any qualified residence interest with respect to the California property in 2015.
As described above, qualified residence interest includes “acquisition indebtedness” with respect to any qualified residence of the taxpayer. IRC § 163(h)(2)(D), IRC § 163(h)(3)(A)(i). Acquisition indebtedness is defined as debt that is used to acquire, construct, or substantially improve a qualified residence and that is “secured by such residence.” IRC § 163(h)(3)(B)(i).
The Tax Court then looked to state law and determined since there was no recorded security instrument, the debt was not “secured by such residence.” Consequently, petitioner has failed to show that his purported debt to the fellow CPA was secured debt so as to constitute acquisition indebtedness pursuant to IRC § 163(h)(3)(B)(i).
Next the Tax Court discussed the fact that the Tax Court could not demonstrate that in 2015 the petitioner made any interest payments to the fellow CPA “in cash or its equivalent.” Although a taxpayer is allowed a deduction for qualified residence interest paid or accrued during the taxable year under IRC § 163(h)(3)(A), a cash basis taxpayer, like the petitioner, cannot deduct an expense incurred unless he actually paid it during the taxable year in cash or its equivalent. See Don E. Williams Co. v. Commissioner, 429 U.S. 569, 577-78 (1977); Treas. Reg. § 1.461-1(a)(1). The petitioner claims that he did not pay interest because the interest was offset by a debt that the CPA owed him, and he saw “no reason to round trip cash between bank accounts simply for the purpose of producing a paper trail.” The Tax Court questioned the existence of such debt, however.
The existence of an obligation is the sine qua non of a debt. Estate of Van Anda v. Commissioner, 12 T.C. 1158, 1162 (1949), aff’d, 192 F.2d 391 (2d Cir. 1951). The giving of a note or other evidence of indebtedness which may be legally enforceable is not in itself conclusive of the existence of a bona fide debt. Id. The Tax Court has long held that an obligation to pay a fixed sum of money may be disregarded as having no value where the facts show that the parties did not contemplate that the obligation would be met. Estate of Maxwell v. Commissioner, 98 T.C. 594, 605 (1992), aff’d, 3 F.3d 591 (2d Cir. 1993).
Until a taxpayer suffers an “economic detriment,” that is to say, until he suffers an “actual depletion” of his property, he has not made a payment which gives rise to an expense deduction. Saviano v. Commissioner, 80 T.C. 955, 964 (1983), aff’d, 765 F.2d 643 (7th Cir. 1985); Rife v. Commissioner, 356 F.2d 883, 889 (5th Cir. 1966), rev’g and remanding 41 T.C. 732 (1964). On the basis of all the evidence the Tax Court concluded that the petitioner no actual obligation with respect to the fellow CPA’s promissory note and that the petitioner suffered no “economic detriment” so as to give rise to any expense deduction.
A Lesson on How Not to Substantiate Residency
Pursuant to IRC § 280A(d)(1)(A), the petitioner is required to show that he used it for personal purposes for more than 14 days in 2015. The record does not establish how many days, if any, petitioner used the California property for personal purposes in 2015. When asked at trial whether he used the California property in 2015, petitioner responded that, although he could not recall exact dates and had no records, but he confidently asserted: “I was at the property at some point in 2015, yeah.”
When asked to elaborate, the petitioner said that he probably had fish tacos, likely went to Hermosa Beach, and possibly saw the sun setting over the ocean. When asked to elaborate, perhaps this time with documentary evidence substantiating his claimed deductions, petitioner could not elocute a cogent, cognizable answer.
Swing and a Miss on Penalties
Dammit Felicia, you had one job. One freaking job.
The IRS has the burden of producing evidence establishing that the “initial determination” of the assessment of the penalty or penalties was personally approved (in writing) by the immediate supervisor of the individual making such determination as required by IRC § 6751(b)(1) (except failure to file, pay, and deposit penalties). See Frost v. Commissioner, 154 T.C. No. 2, *20-*21 (Jan. 7, 2020); Graev v. Commissioner, 149 T.C. 485, 493 (2017). The “initial determination” occurs no later than when proposed adjustments are formally communicated to the taxpayer as part of a communication that advises the taxpayer that penalties will be proposed and giving the taxpayer notice of the right to appeal such penalties. Clay v. Commissioner, 152 T.C. 223, 249 (2019); see also Belair Woods, LLC v. Commissioner, 154 T.C. No. 1, *24-*25 (Jan. 6, 2020).
Exhibit 1 of the IRS’s proof (well, it’s only exhibit, really) was a “notation” on a document entitled “Correspondence Examination Automation Support.” The notation states that the document was “submitted by” someone named Felicia L. Brodnax, with a note that states “6662 penalty.”
Without any other supporting evidence or explanation or elaboration, on brief the IRS argues that this document “reflects the timely managerial approval of the accuracy-related penalty.” The Tax Court took the IRS at its word about as willingly as it took the petitioner’s claim that there was a “debt” between the petitioner and the fellow CPA. Just to be thorough, though, the Tax Court expresses its doubt and then proceeds to eviscerate the claim.
Though Felicia’s note refers to the “6662 penalty,” four separate penalties under IRC § 6662(a) had been asserted against the petitioner. Although the title of IRC § 6662 refers to a (singular) penalty, IRC § 6662 imposes various distinct (plural) penalties, each of which must be separately approved for purposes of IRC § 6751(b)(1). Palmolive Bldg. Inv’rs, LLC v. Commissioner, 152 T.C. 75, 87 (2019).
Finally, the Tax Court poses the following question to the petitioner: Who the bloody hell is this ninny Felecia, and why should we care? To that, apparently, Counsel had no good answer. Thus, the IRS failed to sustain it burden of production regarding the IRC § 6751(b)(2) penalty, and the petitioner escaped liability for the various IRC § 6662(a) penalties asserted against it due to Felicia’s careless disregard for the rules.
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Perhaps Felecia was a Grade 3 clerk, whose job was to stamp papers as mindlessly as a squirrel buries acorns in the fall, but perhaps she really was a supervisor with the authority to approve substantial penalties against taxpayers. This latter thought is disconcerting, and so I will assume for somniferous purposes (lest you, dear reader, lose any sleep over it) that Felecia is some cog in the administrative machine whose two duties in life are stamping whatever is put in front of her and figuring out the best way to get the red ink of bureaucracy from under her long fuchsia acrylic fingernails at night.