Lack of Substantiation and Proof Results in Denial of Deductions and Addition of Penalties

In a recent opinion out of the United States Court of Appeals for the Tenth Circuit, the Court affirmed the Tax Court’s decision denying taxpayers  loss on the sale of a residential property as well as depreciation deductions on property that was purportedly used in taxpayer’s business.[1] Additionally, the Court upheld the imposition of the accuracy related penalties for a substantial understatement under § 6662.[2] The primary basis for the denial of both deductions was lack of evidence that the taxpayer met the requirements for the deductions under the respective statutes.

Facts

Carlos and Pamela Langston (“Langston”) owned a marina known as Port Carlos Marina (“Port Carlos”) which was operated in an entity known as Port Carlos LLC (“LLC”). Port Carlos consisted of two locations. The first location was the primary marina. The second location, known as Masthead Marina (“Masthead”) was about three miles from the primary marina in a cove. Masthead has 50 uncovered boat slips. Prior to purchasing Port Carlos in 2011, Langston purchased a Raptor RV (“RV”) and a Meridian Yacht (“Yacht”). Both the RV and the Yacht were allegedly used exclusively for the business. The Yacht was used as the sales office at Masthead, and the RV was used as additional office space and for nighttime security personnel at Masthead. Both were allegedly contributed to LLC though there was no formal documentation produced to reflect this transfer.

In addition to Port Carlos, Langston also purchased a home known as the “75th Place” in 2001 for $143,000. Langston lived at 75th Place during renovations until 2005. In 2005, Langston moved out of 75th Place and began a second round of renovations which was substantially completed in 2010 at a total cost of more than $722,000. 75th Place remained empty until 2011 when the insurance company threatened to cancel the insurance if it remained unoccupied. Langston rented 75th Place to a fraternity brother for $500 a month since the renter only used the property five days a month. The fair market value for a month’s rent of 75th Place was $2,500 to $2,800. In 2012, Langston listed the property for sale and ultimately sold it for $540,000 in 2013.

Langston claimed depreciation deductions for the RV and the Yacht on their 2012 and 2013 return. They also claimed a depreciation deduction for 75th Place and a loss of $436,633 from the sale of 75th Place.

The 2012 and 2013 returns were prepared by Kathy Burch (“Burch”), a lawyer and a CPA. Burch testified at trial that she did not receive any documentation reflecting the transfer of the RV or the Yacht to the LLC nor did she receive any other documentation related to their use in the business. Burch also testified that she used a cost basis of $1,027,415 to calculate the loss on the sale of 75th Place.

In 2014, the 2012 and 2013 returns were audited. The auditor toured Port Carlos and noted the numerous personal items were observed in the RV and the Yacht that were inconsistent with the purported use as office space or a sales office. Additionally, there was no signage or anything else identifying the Yacht as a sales office. The depreciation deductions for the RV and Yacht were denied as was all deductions related to 75th Place, including the loss on sale. Further, penalties under § 6662 were assessed against Langston for substantially understating the tax due on the 2012 and 2013 returns. The Tax Court upheld the assessments and penalties, finding that Langston failed to meet the substantiation requirements for the Yacht and RV in order to take the depreciation deduction, and failed to prove that 75th Place was converted to income-producing property, a requirement in order for claimed deductions and losses to be available and an issue on which we have previously written about in the Keefe  case here.

Analysis

The Court started its analysis of the issues citing to the famous INDOPCO case which held that deductions are a matter of legislative grace and the taxpayer bears the burden of proving entitlement to a deduction.[3] The Court then moved right into the applicable statutes.

Depreciation of the RV and Yacht

  • 274(d)(4), as it was in effect in 2012 and 2013, disallowed any business deduction, including for “listed property,” where the taxpayer failed to substantiate the business use of the property with adequate records or sufficient evidence to corroborate a taxpayer’s own statement. At the time, § 280F(d)(4) defined “listed property” as “any property used as a means of transportation…[or] any property of a type generally used for purposes of entertainment, recreation, or amusement.” The Court concluded that the Yacht was generally used for entertainment and/or recreation, and the RV was used for transportation, and thus both items were “listed property” to which the substantiation requirements of § 274(d)(4) applied. The Court noted that Langston agreed the two items were “listed property”.
  • 274(d) states that “no deduction or credit shall be allowed … with respect to listed property unless the taxpayer substantiates the requisite elements of … use as set forth” in the regulations. Under Treas. Reg. § 1.274-5T(b)(6)(i)-(iii), the following three elements must each be met for substantiation of listed property: (1) the amount of each business use and the total use of the property for the taxable period; (2) the date of the use; and (3) the business purpose for the use. Treas. Reg. § 1.274-5T(C)(2)-(3) provides for such substantiation by either adequate records or other sufficient evidence.

In order to substantiate the elements of use with adequate records, the taxpayer must show books, records, logs, and documentary evidence, which in combination, are sufficient to establish each element.[4] In order to substantiate the elements of use with other sufficient evidence, the taxpayer must provide his or her own statement with specific information as to each element, and must also provide other evidence which corroborates the taxpayers statement.[5]

At trial in the Tax Court, Langston and the general manager both testified that the Yacht and RV were used exclusively for business purposes. However, only general testimony was offered and no detail was provided such as a date, other witnesses, etc. In addition, Langston failed to provide any records or documents relating to the RV or the Yacht and admitted they had none, a fact the Court seemed to indicate was dispositive in its on right. Accordingly, the Court affirmed the Tax Court’s conclusion that Langston was not entitled to the depreciation deductions for the RV or the Yacht since Langston failed to meet the substantiation requirements of § 274(d).

Loss on the Sale for 75th Place

Individual taxpayers are not allowed to deduct a loss where the transaction is not “entered into for profit”.[6] As such, a loss on the sale of property used by the taxpayer as his or her personal residence is not deductible. However, there is an exception where the property is converted to income-producing property prior to the sale and used for that purpose from the time of conversion up to the time of its sale.[7]

Where property is converted to income-producing property and then later sold, any loss allowed is calculated as the amount realized over the adjusted basis, with the adjusted basis being equal to the lesser of the taxpayer’s adjusted basis in the property or the fair market value at the time of conversion.[8]

Determining whether property is held for the production of income is determined based on the facts and circumstances of the particular case.[9] The Court looks at multiple factors when making this determination, including the followings:

  1. how long the taxpayer used the property as a personal residence;
  2. whether the individual abandoned all personal use of the property;
  3. whether the character of the property was recreational;
  4. whether the property was offered for rent; and
  5. whether the property was offered for sale.[10]

All of these factors were considered by the Tax Court in rendering its opinion. The Tax Court concluded that, based on all the facts and circumstances, Langston did not prove that 75th Place was used for the production of income, and as such the loss was disallowed under § 165. The Court weighed the facts and circumstances and also reached the same conclusion holding the Tax Court conclusion was not clearly erroneous and was supported by substantial evidence. However, the Court went further and disallowed the loss on additional grounds. Langston argued the property was converted to income-producing property in 2005 but did not provide any evidence of the fair market value at the time. Without the fair market value at the time of conversion, there is no way the loss could be calculated.

Accuracy Related Penalties

The accuracy related penalties for substantial understatement of tax may be avoided where there is reasonable cause for such understatement and the taxpayer acted in good faith.[11] In many cases, a taxpayer will rely on the advice of a professional tax adviser in order to meet this standard of reasonable cause and good faith. Reliance on the advice of a professional tax adviser “constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.”[12] However, this exception will not apply “if the taxpayer fails to disclose a fact that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item.”[13] Previous case law has stated that a taxpayer must prove the following in order to rely on the advice of a tax adviser a defense to accuracy related penalties:

  1. the adviser was a competent professional who had sufficient expertise to justify reliance;
  2. the taxpayer provided necessary and accurate information to the adviser; and
  3. the taxpayer actually relied in good faith on the adviser’s judgment.[14]

The Tax Court found that Langston failed to provide necessary and accurate information to the tax adviser. Burch was not provided with any documentation about the contribution of the RV or Yacht to the LLC[15] and no documentation was provided regarding their business use. Burch relied only on the oral statements of Langston. Burch advised Langston that adequate records were needed to show the business use of the RV and the Yacht. Burch also advised Langston that the fair market value of 75th Place was needed to properly calculate the loss on its sale.

The Court concluded that Langston did not meet the reasonable cause, good faith exception. Burch advised Langston to claim deductions for the RV and Yacht, even though she admitted that she knew the property was listed property subject to special substantiation requirements. Burch also advised Langston to deduct the loss on the sale of 75th Place even though she knew the loss could not be properly calculated without the fair market value at the time of conversion.

Conclusion

The Langston case is just another in a long line of cases where deductions were denied due to the taxpayer failing to substantiate or provide evidence as to the deduction. From proving business use of property for a depreciation deduction to proving material participation to deduct an otherwise passive loss, the burden of substantiating the deduction is always placed on the taxpayer, at least initially. In the current case, if Langston had documents showing that the RV and the Yacht were contributed to the LLC[16] and some corroborating evidence of business use such as a sign noting the Yacht was the sales office, the case might have turned out differently, at least as to the depreciation deductions. Taxpayers and their advisors would do well to remember that all losses and deductions must be substantiated, and rarely will a taxpayer’s own testimony, absent other corroborating evidence, be enough to substantiate the deduction.

[1] Langston v. Comm., 126 AFTR 2d 2020-XXX (10th Cir. 2020).

[2] All references to a § or Section are to a Section of the Internal Revenue Code.

[3] INDOPCO, Inc. v. Comm., 502 US 79 (1992).

[4] Treas. Reg. § 1.274-5T(c)(2).

[5] Treas. Reg. § 1.274-5T(c)(3)(i)(A)-(B).

[6] § 165(c)(2).

[7] Treas. Reg. § 1.165-9(b).

[8] Treas. Reg. § 1.165-9(b)(2).

[9] Grant v. Comm., 84 T.C. 809 (1985).

[10] Id.

[11] § 6664(c)(1).

[12] Treas. Reg. § 1.6664-4(b)(1).

[13] Treas. Reg. § 1.6664-4(c)(1)(i).

[14] Neonatology Assocs., P.A. v. Comm., 115 TC 43 (2000).

[15] It is not clear why the Tax Court and the Tenth Circuit placed so much emphasis on the lack of documentation for the transfer of the Yacht and the RV to the LLC as that fact alone is certainly not dispositive of the issue of whether the property was used in the business. Nevertheless, both the Tax Court and the Tenth Circuit mentioned the lack of documentation for the transfer numerous times and seem to place at least a little, if not a significant amount, of weight on this fact in the facts and circumstances test.

[16] See FN 15.