You may think that you don’t stand a chance in fighting the IRS, but you would be wrong. Taxpayers can be successful. Here are some recent disputes that resulted in taxpayer victories that can help you in your future handling of similar tax matters and reduce your taxes…
Mortgage interest on a personal residence can be claimed while a home is under construction, but what if it is never built? One recent Tax Court case focused on Thomas and Cheryl Rose, who bought beachfront property in Fort Myers Beach, Florida, for $1,575,000 in 2006 with the intention of building their dream vacation home. The 2006 sale required the seller to demolish the existing home before closing, which the seller did. The couple borrowed $1.26 million to swing the purchase. To obtain a construction permit, they had to perform numerous activities, which included conducting surveys and core drilling. The permit was granted on February 11, 2008, almost two years after the purchase date.
The owners needed to secure additional financing for the construction but were unable to do so because of plunging home values amid the real estate market collapse. They ultimately sold the property at a loss for $750,000 in June 2009 and never saw their dream come true. However, for 2006 and 2007, they deducted home mortgage interest of $87,016 and $82,201, respectively, on the grounds that the home was “under construction.”
IRS Position: The couple cannot deduct the interest because construction of the home never actually started.
Tax Court Ruling: Construction includes work done in applying for permits, doing preparatory measurements, surveying, drawing plans, demolishing an existing home and clearing the site. The court rejected the IRS argument that “under construction” includes only physical construction activity such as pouring the foundation.
Lesson: In trying to write off interest before physical construction begins, a homeowner should keep a log of activities “in furtherance of construction.”
Thomas G. Rose and Cheryl G. Rose, TC Summary Opinion 2011-117
A gain on the sale of a personal residence is determined by comparing the sale price with the cost basis, which includes the original price that the owner paid for the home and the costs of capital improvements made over the years. However, many home owners fail to keep records and receipts proving the amount spent on these improvements. Can they be estimated?
In April 2002, Louis Greenwald bought a home in Santa Barbara, California. He made various improvements to the home but retained only some of the invoices. He sold the home in 2005 for $2,650,000. He reported a capital gain of $638,802. His cost basis reflected improvements totaling $387,735.
IRS Position: The gain was $356,515 more than he claimed because he could not substantiate most of the improvements.
Tax Court: The court applied the Cohan doctrine, under which a court can allow a claimed expense even if the taxpayer cannot fully substantiate it. But this requires what the court called an “evidentiary basis” for claiming the expense. The Cohan doctrine typically is used for unsubstantiated travel and entertainment expenses, but the court said that it could and would apply the doctrine to improvements to a residence. It allowed all but $950 of Greenwald’s claimed improvements because he was able to list what they were and to estimate how much each cost.
What to do: Even though receipts were not necessary in this case, it’s best to keep them, and you should maintain an ongoing record of capital improvements to your home to minimize the gain on an eventual sale. Find a list of improvements to track in IRS Publication 523, Selling Your Home, at www.irs.gov.
Louis Greenwald, TC Memo 2011-239
Volunteers can claim a tax deduction for out-of-pocket costs—these costs are considered a charitable contribution—but the costs must be substantiated.
In a recent case, Jan Elizabeth Van Dusen of Oakland, California, cared for a total of 70 to 80 feral cats under a foster-cat program. She paid for their food, veterinary bills (for tests, treatment, vaccines and surgery) and other pet supplies totaling $12,068. She had receipts, credit card bills and other documentary proof of her outlays. In 2004, she claimed those costs for a tax deduction.
In another case, Tawana Bradley of Louisville, Kentucky, acting as a volunteer coach for a football cheerleading squad, paid for pizza, party favors and other supplies for a squad party totaling $162.27. She had receipts. In 2006, she claimed this cost for a tax deduction.
IRS Position: Volunteer expenses are subject to the same substantiation rule as cash contributions—they must be proven by canceled checks or bank statements, which these two taxpayers did not have.
Amounts of $250 or more also must be substantiated by a written acknowledgment from the charity.
Tax Court Ruling: Volunteer expenses up to $249 can be substantiated by receipts, credit card slips and other documentary proof—they are acceptable substitutes for canceled checks. Although Van Dusen was able to declare only a small portion of her expenses, the ruling set a precedent for other cases, such as Bradley’s.
Caution: If the amount to be deducted is $250 or more, you do need a written acknowledgment from the charity, just as if you had made a cash donation.
Lesson: Learn the substantiation rules for charitable donations (go to IRS Publication 526, Charitable Contributions, at www.irs.gov) to claim the full extent of your out-of-pocket costs.
For example, track vehicle mileage incurred on behalf of charitable activities so that you can deduct mileage at the rate of 14 cents per mile.
Jan Elizabeth Van Dusen, 136 TC No. 25 (2011); Tawana Bradley, TC Summary Opinion 2011-120
An activity that loses money may be treated as a hobby by the IRS—meaning that expenses in excess of the business’s income are not deductible—unless the taxpayer can demonstrate that there is a “profit motive.”
In one recent case, Peter Morton, cofounder of the Hard Rock Cafe, owned or controlled several businesses related to his Hard Rock brand. One was an S corporation (a corporation that does not pay federal income tax) that owned a Gulfstream jet. This S corporation never made money.
IRS Position: Losses from the S corporation that owns the plane are nondeductible because the S corporation represented a hobby activity.
Federal Claims Court: The determination of whether a taxpayer has a profit motive (and therefore is not engaged in a hobby activity) can be based on the “aggregation” of business activities—treating them as related activities—rather than considering the businesses as entirely separate. In this case, Morton’s various corporations were interrelated in terms of their activities—and all furthered the Hard Rock brand. As detailed by flight logs, he used the plane for personal and business travel, including the promotion of the Hard Rock brand and activities related to the Hard Rock Hotel and Casino in Las Vegas. Since his use was in furtherance of his corporate “brand,” it supported his overall profit motive and so was not a hobby activity.
Lesson: You don’t have to be a mogul (or own a jet) for this ruling to help you. What it means is that you can maintain separate but related companies—even small companies—while aggregating them only for the tax purpose of demonstrating a profit motive.
Morton v. United States, No. 08-804C (Fed. Cl 2011)
Source: Barbara Weltman, Esq., an attorney in Millwood, New York, is author of J.K. Lasser’s 1001 Deductions and Tax Breaks (Wiley) and publisher of Big Ideas for Small Business, a free monthly e-newsletter. www.BarbaraWeltman.com