Tuesday, September 29, 2020
The U.S. Tax Court and the other federal courts issue numerous tax opinions throughout each year. From my perspective, many of them deal with penalties and procedure and aren’t really that instructive on matters of substantive tax law. Recently, however, the Tax Court and the Colorado federal district court have issued some opinions that are very instructive on issues that practitioners need to pay attention to and clearly understand. Clients find themselves in these issues not infrequently.
Recent court opinions of relevance to taxpayers and their practitioners – it’s the topic of today’s post.
IRS Liens and the “Nominee” Theory
The IRS has numerous “weapons” at its disposal to collect on tax debts. One of those can come into play when a taxpayer with outstanding tax obligations transfers property to a third party or entity in an attempt to sever the taxpayer’s ties to the property. If those ties are indeed severed, perhaps the property can be effectively shielded from levy and execution to pay the taxpayer’s tax bills. But, if the taxpayer retains some (or all) of the beneficial use of the property, the IRS may be able to successfully claim that the third party or entity is really the taxpayer’s “nominee.” Actual transfer of legal title to the property really doesn’t matter. See Internal Revenue Manual, Part 22.214.171.124.4 (Jan. 24, 2012).
In Cantliffe, the defendant bought residential real estate in a wealthy Denver suburb and soon thereafter transferred it to a grantor trust naming the defendant and his then-wife as beneficiaries. The defendant’s father-in-law was named as the trustee. The trust terms gave the beneficiaries the “right to participate in the management and control of the Trust Property,” and directed the Trustee to convey or otherwise deal with the title to the Trust Property. The trust terms also gave the beneficiaries the right to receive the proceeds if the property was sold, rented or mortgaged. The defendant continued to personally make the mortgage payments, and pay the property taxes and homeowner association dues. In addition, the defendant personally paid the electricity, gas and water bills for the home. The defendant claimed a deduction on his personal tax return for mortgage interest and claimed a business deduction for an office in the home. While the defendant filed personal returns for 2005-2008 and 2010, he did not pay the tax owed. The IRS assessed tax, penalties and interest against the defendant personally.
In early 2019, the IRS notified the defendant of the balance due for each tax year and recorded a notice of federal tax lien with the county for each year at issue. The IRS also issued a lien for the Trust as the defendant’s nominee. The IRS subsequently sought to enforce its liens and a judgment that the defendant was the true owner of the trust property. The court, agreeing with the IRS, noted that the defendant’s property and rights to the property may include “not only property and rights to property owned by the taxpayer but also property held by a third party if it is determined that the third party is holding the property as a nominee…of the delinquent taxpayer.” The court noted that six factors were critical in determining that the Trust held the property as the defendant’s nominee: 1) the Trust paid only ten dollars for the property; 2) the conveyance was not publicly recorded; 3) the taxpayer resided in the property and made the property’s mortgage payments and property taxes and housing association dues payments; 4) the taxpayer enjoyed benefits from the property because he claimed mortgage interest deductions related to the property; 5) the taxpayer had a close relationship with the Trust because he created it and named himself as a beneficiary; and 6) the defendant continued to enjoy the benefits of the property transferred to the Trust.
Thus, the federal tax liens against the defendant also attached to the Trust property and the IRS could seize the property in payment of the defendant’s tax debt.
No Loss Deduction on Sale of Vacation Property.
Duffy v. Comr., T.C. Memo. 2020-108
The petitioners, a married couple, bought a vacation property but became unable to pay the debt on the property. They sold the property and the bank holding the obligation agreed to accept an amount of the sale proceeds that was less than the outstanding balance as full satisfaction of the debt. The debt was nonrecourse and, as such, the amount of discharged debt was included in the petitioner’s amount realized upon sale of the property and was not CODI. The petitioners claimed a loss on sale to the extent of the basis in the property exceed the amount realized from sale. However, the Tax Court noted that because the property was converted from personal use to rental use, the basis upon conversion cannot exceed the property’s fair market value for purposes of the loss computation. The Tax Court held determined that the petitioners failed to establish the basis in the property at the time of conversion.
These types of properties are commonly referred to as “mixed-use” properties. Many vacation homes may fall into this category. I.R.C. §280A(c)(5)(B) requires a vacation home rental expense (real estate taxes and mortgage expense) allocation be made. That allocation is particularly important when the property is unoccupied for significant periods of time. The expenses are to be allocated based on the ratio of total rental days to the total number of days in the year. Bolton v. Comr., 77 T.C. 104 (1981), aff’d., 694 F.2d 556 (9th Cir. 1982); McKinney v. Comr., T.C. Memo. 1981-337, aff’d., 732 F.2d 414 (10th Cir. 1983). However, the IRS has never amended IRS Pub. 527 to reflect its loss in the Bolton and McKinney cases and still maintains that its method is the only permissible method. The IRS position, which was rejected in both cases, is that the rental portion of real estate taxes and mortgage interest is to be allocated by the ratio of total rental days to the total number of days the property was used for any purpose during the year. Prop. Treas. Reg. §1.280A-3(c). The IRS position is also not supported by legislative history. See S. Rep. No. 94-938, 94th Cong. 2d Sess., at 154.
While not at issue in the case, the Tax Cuts and Jobs Act (TCJA), could influence the tax consequences for taxpayers with mixed-use properties. The TCJA increased the standard deduction (essentially doubling it) and also limited itemized deductions for state and local taxes and home mortgage interest. These aspects of the TCJA can have an impact on the affect the vacation home rental expense allocation under Sec. 280A(c)(5)(B) between personal and rental use, particularly for a dwelling that is unused for significant periods. Generally speaking, for taxpayers that itemize deductions the judicial method may produce a better tax result in situations where more of the real estate taxes and mortgage interest are allocated to personal use. That’s because they are deducted on Schedule A where they are not disallowed by exceeding rental income, along with other, direct rental expenses. See I.R.C. §280A(c)(5)). Taxpayers in states within the Ninth and Tenth Circuits have their option of which approach to use.
No $1.4 Million NOL Carryforward
Gebman v. Comr., T.C. Memo. 2020-1
The TCJA provided that for years ending after 2017, the rule allowing the carryback of a net operating loss (NOL) was repealed, except for farm NOLs, which are carried back two years. IRC § 172(b)(1)(B)(i). Taxpayers with a fiscal year ending in 2018 were denied the NOL carryback, except the farm NOL was allowed the two-year carryback. A taxpayer can elect to forgo the two-year carryback. The election is irrevocable. IRC § 172(b)(3). Under the TCJA, NOLs generated in years beginning after 2018 were allowed in the carryover year only to the extent of 80 percent of the taxpayer’s taxable income determined without regard to the NOL deduction. The 80 percent provision also applied to the two-year farm NOL carrybacks for NOLs generated in years beginning after 2017. Post-2017 NOLs do not expire. NOLs arising in taxable years ending December 31, 2017 and earlier retained their 20-year carryover restriction. NOLs can be carried forward indefinitely.
In early 2020, in response to the economic impact of the spread of a virus from China to the United States, the Congress enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Under that legislation, a taxpayer must carryback NOLs from the 2018, 2019 and 2020 tax years to the previous five years unless the taxpayer election to waive the carryback. The CARES Act also suspends the 80 percent of taxable income limitation through the 2020 tax year. IRC § 172(a)(1). The two-year carryback provision for farmers was temporarily removed. Post-2017 NOLs will be subject to the 80 percent of taxable income limitation for years beginning in 2021 and following.
The procedure to carryforward an NOL must be followed closely. In Gebman, the petitioners, a married couple, carried forward a $1.4 million net operating loss (NOL) and deducted it against their income for the carryforward year. The IRS denied the deduction for failure to satisfy Treas. Reg. §1.172-1(c) which requires that a taxpayer claiming an NOL deduction must file with the return “a concise statement setting forth the…amount of the [NOL] deduction claimed and all material and pertinent facts relative thereto, including a detailed schedule showing the computation of the…[NOL] deduction.”
The Tax Court agreed and noted that the regulation was in accordance with the burden of establishing both the existence of the NOLs for prior years and the NOL amounts that may properly be carried forward to the tax year at issue. The Tax Court determined that the petitioners failed to satisfy this burden because they provided no detailed information supporting the NOL – both the NOLs for the prior years and the amounts that can be carried forward. The only “proof” the petitioners had was submitted copies of tax returns on which they reported the losses. The Tax Court declined to hold that submitted copies of returns was sufficient substantiation.
Good tax planning requires an astute knowledge of the Code and an awareness of how those Code provision details apply in common situations. These recent Tax Cases are good illustrations of how complex the Code can be and how traps can be avoided and favorable tax results can be obtained.