On October 14, 2020, the Tax Court issued a Memorandum Opinion in the case of Wienke v. Commissioner (T.C. Memo. 2020-143). The issues before the court in Wienke v. Commissioner are numerous and varied; in fact, the Tax Court lists eight specific, separate issues.

Background to Wienke v. Commissioner

The petitioners, husband and wife at the time, owned a number of California rental properties.  One was foreclosed upon and the debt was discharged.  The lender issued the petitioner-wife a Form 1099-C for $80,000 (checking the box that she was personally liable for the debt).

The petitioners filed married filing separately.  The petitioner-wife reported 18 of the rental properties on her return, and the petitioner-husband reported the other rental properties on his return (at least 10 properties).  The petitioners reported $330,000 rental income in 2012 and $251,000 in 2013, with nearly $330,000 in expenses for both years.  The petitioner-wife did not report any wage income in 2012 or 2013.

Letter of Determination

The IRS determined that the petitioners had incorrectly reported income from the rental properties on their returns. He calculated the petitioners’ total income and expenses for all 28 properties and reallocated half of the income and expenses to the petitioner-wife. The IRS did not make any adjustments to the rental income reported or expense deductions claimed other than the depreciation deductions. The IRS used county property tax records to calculate each rental property’s cost basis starting when it was placed in service and then determined the proper depreciation deduction schedule for each property. The IRS reduced the petitioner-wife’s collective depreciation deductions by $56,558 and $39,803 for 2012 and 2013, respectively, on the basis of these schedules.

The IRS further determined that the petitioners had together claimed $1,026,746 of depreciation deductions for the rental properties from 1994 to 2011 but were entitled to only $539,935. The IRS made an IRC § 481(a) adjustment to the petitioners’ total 2012 income to include the $486,811 of disallowed depreciation deductions for all 28 rental properties for those prior years and allocated half of that amount ($243,405) to the petitioner-wife.  Finally, the IRS determined that the petitioner-wife failed to report cancellation of indebtedness income.

Cancellation of Debt Income

Generally, a taxpayer must include income from the discharge of indebtedness. IRC § 61(a)(12); Treas. Reg. § 1.61-12(a); Jelle v. Commissioner, 116 T.C. 63, 67 (2001) (citing United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931)). Some accessions to wealth that would ordinarily constitute income may be excluded by statute or other operation of law. Commissioner v. Dunkin, 500 F.3d 1065, 1069 (9th Cir. 2007), rev’g 124 T.C. 180 (2005). Even so, given the clear Congressional intent to exert the full measure of its taxing power, exclusions from gross income are construed narrowly in favor of taxation.” Id. (quoting Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955)) (citing Merkel v. Commissioner, 192 F.3d 844, 848 (9th Cir. 1999), aff’g 109 T.C. 463 (1997)).

The petitioner-wife claimed that her debt with Seterus and petitioner-husband’s debts with Fannie Mae and Freddie Mac were all nonrecourse debts because the lenders did not pursue either of them for the outstanding balances after discharging the debts. Therefore, she argues, these canceled debts should be excluded from her income.

Indebtedness is generally characterized as nonrecourse if the creditor’s remedies are limited to particular collateral for the debt and as recourse if the creditor’s remedies extend to all the debtor’s assets. Great Plains Gasification Assocs. v. Commissioner, T.C. Memo. 2006-276 (citing Raphan v. United States, 759 F.2d 879, 885 (Fed. Cir. 1985)). A debtor’s foreclosure of a property subject to a nonrecourse liability is treated as a sale or other disposition of the property, and any resulting income constitutes gain on the disposition of property rather than discharge of indebtedness income. See Coburn v. Commissioner, T.C. Memo. 2005-283.

The flaw in the petitioner-wife’s argument is that the Forms 1099-C issued for the canceled debts indicated that the borrower was personally liable for repayment. When an information return, such as Form 1099-C, is the basis for the determination of a deficiency, the burden of production may shift to the IRS. See IRC § 6201(d); Del Monico v. Commissioner, T.C. Memo. 2004-92. If a taxpayer in a Tax Court proceeding asserts a reasonable dispute with respect to any item of income reported on an information return and has cooperated fully, then the IRS must produce reasonable and probative information concerning the deficiency in addition to the information return. IRC § 6201(d).

Ultimately, the Tax Court found that the petitioner-wife did not raise a reasonable dispute as to the accuracy of any of the Forms 1099-C. In particular she did not provide any documentation, such as the loan agreements, to support her argument that the debts were nonrecourse. She even admitted that the lenders could have collected from the petitioners. Thus, the petitioners failed to shift the burden to the IRS under IRC § 6201(d). See, e.g., Carlson v. Commissioner, T.C. Memo. 2012-76, aff’d, 604 F. App’x 628 (9th Cir. 2015). Accordingly, we hold that the debts were all recourse debts and sustain respondent’s inclusion of this cancellation of indebtedness as part of the petitioner-wife’s gross income for 2012 and 2013. See IRC § 61(a)(12); Treas. Reg. § 1.61-12(a).

Deductions

A taxpayer must prove her entitlement to any deductions and credits claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers bear the burden of substantiating their claimed deductions by keeping and producing records sufficient to enable the IRS to determine the correct tax liability. IRC § 6001; INDOPCO, 503 U.S. at 84; Treas. Reg. § 1.6001-1(a), (e).

IRC § 162 allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. IRC § 162(a); Treas. Reg. § 1.162-1(a). An expense is “ordinary” if it is normal, usual, or customary in the taxpayer’s trade or business or it arises from a transaction of common or frequent occurrence in the type of business involved. Deputy v. du Pont, 308 U.S. 488, 495 (1940).

An expense is “necessary” if it is appropriate and helpful to the taxpayer’s business, but it need not be absolutely essential. Commissioner v. Tellier, 383 U.S. 687, 689 (1966) (quoting Welch v. Helvering, 290 U.S. at 113). In contrast, a taxpayer may not deduct personal, living, or family expenses unless the law expressly provides otherwise. IRC § 262(a). The determination of whether an expense satisfies the requirements of section 162 is a question of fact. Cloud v. Commissioner, 97 T.C. 613, 618 (1991) (citing Commissioner v. Heininger, 320 U.S. 467, 473-475 (1943)).

Deductions versus Capital Expenses

The distinction between a current expense and a capital expenditure is important in that business expenses are currently deductible, while a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. See INDOPCO, 503 U.S. at 83-84; see also Smith v. Commissioner, 300 F.3d 1023, 1028-29 (9th Cir. 2002), aff’g Vanalco, Inc. v. Commissioner, T.C. Memo. 1999-265; Lychuk v. Commissioner, 116 T.C. 374, 410 (2001).

Depreciation

IRC § 167 generally allows a deduction for the exhaustion and wear and tear of property used in a trade or business or for the production of income. To determine the annual depreciation deduction for the property, taxpayers are required to use the modified accelerated cost recovery system (MACRS) outlined in IRC § 168. MACRS dictates the applicable depreciation method, recovery period, and convention to use in calculating a depreciation deduction. IRC § 168(a).

For residential rental property MACRS specifically dictates that taxpayers use the straight-line method and a recovery period of 27.5 years. See IRC § 168(b)(3)(B), (c). Land generally is not depreciable; however, improvements or physical developments added to land may be depreciable. Treas. Reg. § 1.167(a)-2.  If a taxpayer pays a lump sum for property comprising both depreciable improvements and nondepreciable land, she must apportion the cost between the land and the improvements for purposes of calculating depreciation deductions. Treas. Reg. § 1.167(a)-5; see also Broz v. Commissioner, 137 T.C. 46, 58 (2011). Taxpayers also may depreciate the costs of capital improvements they make to residential rental property after purchasing the property, but they bear the burden of establishing and substantiating these costs. See IRC § 167; IRC § 263; Chico v. Commissioner, T.C. Memo. 2019-123, at *37-*38.

Change in Method of Accounting

IRC § 481(a) authorizes the IRS to adjust a taxpayer’s income for the year the taxpayer changes her method of accounting, whether initiated by the taxpayer or the IRS. See Suzy’s Zoo v. Commissioner, 273 F.3d 875, 883 (9th Cir. 2001), aff’g 114 T.C. 1 (2000); see also Treas. Reg. § 1.446-1(e)(2)(ii)(d)(5)(iii) (providing that a “change from an impermissible method of computing depreciation” to a permissible method “results in a IRC § 481 adjustment”). When the change in method of accounting is involuntary (i.e., not initiated by the taxpayer), the entire amount of the adjustment is included in the taxpayer’s income in the first taxable year in which taxable income is computed under a method of accounting that is different from the method that was used in the prior year. Treas. Reg. § 1.481-1(c)(3).

A taxpayer’s taxable income for the year of a change in method of accounting is computed by taking into account those adjustments which are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted. IRC § 481(a)(2); Treas. Reg. § 1.481-1(a)(1); see also Mingo v. Commissioner, 773 F.3d 629, 635 (5th Cir. 2014), aff’g T.C. Memo. 2013-149. The adjustment for the year of the change may reflect tax liabilities for years when the statute of limitations would otherwise bar reopening the taxpayer’s prior returns. Suzy’s Zoo, 273 F.3d at 884 (citing Rankin v. Commissioner, 138 F.3d 1286, 1288 (9th Cir. 1998), aff’g T.C. Memo. 1996-350); see also Mingo v. Commissioner, 773 F.3d at 636.

Congress has mandated through its enactment of section 481 that an adjustment under IRC § 481 generally must be made to remove the threat of a double benefit or omission whenever there is a change in a method of accounting. Wasco Real Props. I, LLC v. Commissioner, T.C. Memo. 2016-224, *50, aff’d, 744 F. App’x 534 (9th Cir. 2018); see also Suzy’s Zoo, 273 F.3d at 883. A change in method of accounting includes not only a change in the taxpayer’s overall plan of accounting but also a change in the treatment of any material item used in such overall plan. Treas. Reg. § 1.446-1(e)(2)(ii)(a).

An item is “material” when it affects the timing of reporting income or deductions, as opposed to the amount (how much income is reported), or whether a deduction would ever have been appropriate. Rankin, 138 F.3d at 1288; see Treas. Reg. § 1.446-1(e)(2)(ii)(a). When an accounting practice postpones the reporting of income, rather than permanently avoiding the reporting of income over the taxpayer’s lifetime, it involves the proper time for reporting income. Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 510 (1989); see also Primo Pants Co. v. Commissioner, 78 T.C. 705, 722 (1992) (noting that materiality turns on whether the items affect timing).

Cost of Goods Sold (COGS)

A business is allowed to offset its gross receipts with COGS to compute gross income. See Metra Chem. Corp. v. Commissioner, 88 T.C. 654, 661 (1987); Treas. Reg. § 1.61-3(a); Treas. Reg. § 1.162-1(a). COGS is not a deduction and is not subject to the limits on deductions in IRC § 162, Metra Chem. Corp., 88 T.C. at 661, but any amount reported as COGS still must be substantiated.  King v. Commissioner, T.C. Memo. 1994-318, *2, aff’d without published opinion, 69 F.3d 544 (9th Cir. 1995).

(T.C. Memo. 2020-143) Wienke v. Commissioner

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