Federal Income Tax Update: Part 2
By I. Audit Statistics: What Are Your Chances of Being Audited?
The 2022 Internal Revenue Service Data Book contains audit statistics for years 2012 through 2020, as of the fiscal year ended September 30, 2022 (FY 2022). For tax years 2018 and earlier, the statute of limitations for audits had generally expired as of September 30, 2022. However, for 2019 and 2020 returns, the statute of limitations has yet to expire, so additional returns of those years may be audited.
For 2012 through 2018, audit rates dropped significantly. For example, individual tax returns had an audit rate of 0.8% for 2012 returns versus 0.3% for 2018. In addition, for individuals with income between $1 million and $5 million, the audit rate dropped from 4.9% for 2012 returns to 1.2% for 2018 returns.
The overall audit rate for C corporations dropped from 1.3% for 2012 returns to 0.5% for 2018 returns. For partnerships and S corporations, the audit rate for 2012 returns was 0.3% and 0.4%, respectively, compared to 0.1% and 0.1% for 2018 returns.
In FY 2022, 21.4% of audits were field audits. The others were correspondence audits.
Below are the FY 2022 audit statistics for 2020 tax returns:
A. Audit Rates for Individual Tax Returns.
During FY 2022, only 0.2% of individual income tax returns filed for 2020 were audited (down from about 0.3% for 2019 returns).
Total 2020 Individual Returns Audited in FY 2022: 0.2%
- No positive income 2%
- $100,000 to $200,000 1%
- $500,000 to $1 million 4%
- $1 million to $5 million 4%
- $5 million to $10 million 7%
- $10 million or more 4%
B. Audit Rates For Partnerships and S Corporations.
For partnership and S corporations, the FY 2022 audit rate for 2020 returns was less than 0.5% (down from 1% for 2019 returns).
C. Audit Rates for C Corporations.
C corporation returns filed for 2020 had an audit rate of 0.5% during FY 2022 (down from 2.9% for 2019 returns).
Total 2020 C Corporation Returns Audited in Fiscal Year 2022: 0.5%
(1) Assets $1 million to $5 million 4.0%
(2) Assets $5 million to $20 million 11.5%
(3) Assets $20 million or more 17.7%
D. Schedule C Returns.
Not surprisingly, the audit rates for Schedule C returns are much higher than for other individual returns. Schedule Cs filed for 2018 with receipts of $100,000-$200,000 had a 2.4% audit rate. Schedule C returns filed for 2018 with income over $200,000 had a 1.9% audit rate. The IRS has not published similar Schedule C audit statistics for 2019 or 2020 tax returns.
E. Offers in Compromise.
For FY 2022, the IRS received around 36,000 offers in compromise but accepted only about 13,000.
F. Criminal Case Referrals.
The IRS initiated 2,558 criminal investigations for FY 2022. The IRS referred 1,837 cases for criminal prosecutions (557 for legal source tax crimes, 785 for illegal source financial crimes, and 495 for narcotics-related financial crimes) and obtained 1,564 convictions. For convictions, 1,151 were incarcerated.
II. Cattle Ranching was For-Profit Activity; Paul Wondries vs. Commissioner, TC Memo 2023-5
Wondries is a taxpayer victory illustrating how one should document a case and build a defense to an IRS hobby loss attack. Mr. Wondries was a successful car dealer entrepreneur. He had operated around twenty-three car dealerships, many of which he turned from losing ventures to profitable ones. In 2004, Mr. Wondries diversified his business interests by acquiring a 1,100-acre cattle ranch in California. It included a main house, a guest house, a foreman’s house and wells and natural springs. The ranch contained 30 miles of road access.
As Mr. Wondries had no prior experience in ranching, he hired Robert Palm, an experienced ranch foreman. Mr. Palm had profitably managed two other ranches, both of which were over 1,000 acres. He had almost 20 years of ranching experience in California, Nevada, Oregon, Idaho, Texas and Nebraska. Mr. Palm took care of all aspects of running the ranch.
Soon after Mr. Wondries purchased the ranch, severe drought hit California. To curb his losses, Mr. Wondries sold all of his cattle within a few months of purchasing the ranch. Mr. Wondries considered leasing the ranch for hunting purposes but determined the ranch was too small to sustain a sufficient population of wild animals, and the liability risks outweighed any potential revenue. Mr. Wondries ultimately determined he could not turn a profit by raising cattle. He decided to turn from an operating ranch focus to an investment focus that would someday allow him to sell his investment at a gain.
Although Mr. Wondries relied on his ranch foreman and independent contractors for most of the ranch tasks, Mr. and Mrs. Wondries often personally performed tasks while visiting. Mr. and Mrs. Wondries never used the ranch for vacation purposes; instead, the Wondries used one of their other vacation properties for leisure. Mr. and Mrs. Wondries performed accounting and payroll functions for the ranch. They kept detailed records of expenses, including copies of cancelled checks and receipts. Mr. Wondries used the CPA for his car dealerships to review his ranch accounting work. Notwithstanding these efforts, Mr. and Mrs. Wondries never earned a profit at their ranch.
The IRS challenged the Wondries’ attempts to use their ranch losses to offset their other taxable income. The court upheld the deductibility of the Wondries’ ranch losses based on the multi-factor test under the Section 183 regulations.
1. Manner in which the Taxpayer Undertakes the Activity.
The Wondries hired Mr. Palm to oversee the day-to-day operations of the ranch and maintained complete and accurate books and records of all ranch activities. The Wondries had a business plan that initially included guided hunting expeditions. Those plans were later abandoned, and the Wondries adopted a long-term investment strategy.
2. Expertise of the Taxpayers and their Advisors.
Although the Wondries had no prior ranching experience, Mr. Palm had extensive experience in successfully operating cattle ranches.
3. Time and Effort Expended by the Taxpayer in Carrying on the Activity.
Mr. and Mrs. Wondries admitted they spent little personal time on the ranch. The court, however, stated that did not necessarily indicate a lack of for-profit motive where the taxpayer hires competent and qualified persons to carry on the activity.
4. Expectation Assets Used in the Activity May Appreciate in Value.
The Wondries credibly testified they had two plans when they initially purchased the ranch: an operational one and investment one. The operational plan was to raise cattle and provide guided hunting expeditions. The Wondries’ backup plan was to improve the ranch and hold it as a long-term investment. Once the Wondries realized they could not earn a profit from raising cattle or providing guided hunting expeditions, they began making improvements to ranch structures and landscape to increase the ranch’s investment value.
The court noted a for-profit objective may be inferred where expected appreciation in the activities’ assets may exceed operating expenses sufficient to recoup accumulated losses. Previous cases have not required the taxpayer to recoup all past losses. Instead, the question is whether the taxpayer would recoup the losses between the years at issue and the hoped for profitable future. Robison v. Commissioner, TC Memo 2018-88 and Helmick v. Commissioner, TC Memo 2009-220. An overall profit motive is present if net earnings and appreciation are sufficient to recoup losses sustained in intervening years.
The Wondries initially purchased the ranch for $2 million. They believed the ranch was worth between $5.5 and $6 million in 2015 through 2017. Although the ranch was losing about $300,000 each year, the Wondries would make an overall profit on the ranch based on the estimated value.
5. Success of the Taxpayer in Carrying on Similar Activities.
Mr. Wondries had a track history of turning unprofitable businesses into profitable ones. Mr. and Mrs. Wondries, however, never earned a profit on the ranch since they purchased it in 2004. There were unforeseen circumstances, such as a drought early during farm operations. Even though droughts are common in California, they are beyond the taxpayer’s control. Under the Section 183 regulations, if losses are sustained because of unforeseen or fortuitous circumstances that are beyond the control of the taxpayer (such as drought, disease, fire, theft water damages or other involuntary conversions or a depressed market), losses are not an indication the activity is not engaged in for profit. See Treas. Reg. 1.183-2(b)(6). Because Mr. Wondries could not prove his losses were caused by the early drought, this factor was in favor of the IRS.
6. Amount of Occasional Profits.
This factor clearly weighed against Mr. and Mrs. Wondries because they never earned a profit during any year.
7. Financial Status of the Taxpayer.
In each of the three audit years, the Wondries reported over $9 million of total income from other sources. Thus, the ranch losses created substantial tax benefits to the Wondries, which was a factor weighing against them.
8. Elements of Personal Pleasure or Recreation.
The Wondries had numerous properties in desirable locations where they often vacationed. This factor, therefore, weighed in favor of Mr. and Mrs. Wondries.
The court concluded this was a close case, but after weighing all the facts and circumstances, concluded Mr. and Mrs. Wondries engaged in their ranching activities for profit.
III. Poor Record Keeping and Following Poor Business Practices Result in Denial of Deductions; Skolnick v. Commission (3rd 2023).
Mr. Skolnick and several of his family members formed Bluestone Farms, LLC to operate a horse farm in New Jersey. Bluestone Farms bought, sold, bred and raced Standardbred horses. During the years at issue (2010 through 2013), the family kept between and 15 and 25 horses at Bluestone Farms. Bluestone Farms employed between 7 and 10 employees. During 2010 through 2013, Bluestone lost more than $3.5 million. The entire Skolnick family lost more than $11.4 million between 1998 and 2013.
The Third Circuit upheld the decision of the Tax Court (Skolnick v. Commission, TC Memo 2021-139) ruling that the Skolnicks could not deduct losses from Bluestone Farms, LLC. The court held because the Skolnicks failed to operate the horse farm in a business-like manner, their horse breeding activity was not engaged in for profit under Section 183. In addition, the court refused to allow Mr. and Mrs. Skolnick to carry over NOL losses arising from their horse activities in years prior to 2010 because they failed to substantiate them. The court, however, held the Skolnicks were not liable for accuracy-related penalties under Section 6662 because they had relied on the advice of their CPA advisors.
The court applied the nine-factor test in the Section 183 regulations and agreed with the Tax Court, which found five factors favored the IRS, three factors were neutral, and only one factor favored the Skolnicks
Factor 6, History of Losses.
This factor was by far the most important to the Tax Court and the Court of Appeals.
Factor 1, Manner of Conducting Business Activity.
The Court of Appeals and the Tax Court found the lack of a business plan and the absence of employee budgets, as well as payment of personal expenses out of the Bluestone Farms operating account, were evidence of failure to operate the activities in a business-like manner.
Factor 8, Financial Status of the Taxpayers.
The court noted the taxpayers eliminated substantially all of their taxable income from other sources by offsetting losses from the horse breeding activities.
Other Factors.
The Skolnicks failed to keep adequate records. They did not demonstrate they anticipated profits in the future, or future property value increases would be sufficient to offset their substantial losses in the past. The court noted the Skolnicks derived personal pleasure from horse breeding activities. Although the Skolnicks consulted experts and made some operational changes over time and had some previous experience in horse breeding activities, those factors alone failed to support an overall for-profit motive.
NOL Carryforwards.
The court upheld the Tax Court determination that the Skolnicks did not prove the existence of NOL carryforwards generated from their horse activities in earlier years. The Skolnicks did not produce any meaningful evidence to support their loss calculations. Simply providing copies of their income tax returns for prior years was insufficient. Roberts vs. Commissioner, 62 TC 834 (1974).
The Skolnicks also attempted to use as evidence an IRS no change letter they received in 2010 after the IRS audited their 2008 tax return. During the 2008 audit the IRS never challenged the hobby status of Bluestone Farms. The no change letter simply said the IRS was proposing no changes to their 2008 tax return. Since the prior audit made no finding whether the horse activities were a for-profit endeavor, the Skolnicks could not use the no-change letter to support their NOL carryforwards.
IV. Assignment of Income Doctrine and a Defective Appraisal Doom Charitable Contributions Deduction; Hoensheid vs. Commissioner
Mr. and Mrs. Hoensheid made a generous gift of stock in their closely held business, Commercial Steel Treating Corp. (“CSTC), to Fidelity Charitable Gift Fund (“Fidelity Charitable”). Fidelity Charitable is a Section 501(c)(3) organization that administers donor advised funds. Almost immediately after the charitable gift, Fidelity Charitable sold the CSTC stock.
The Tax Court held, under the assignment of income doctrine, the Hoensheids had to recognize all of the capital gain on the gifted stock because the effective transfer of the stock to the charitable organization did not occur until all of the deal points had been reached on a stock sale. That was so even though the sales contract was not executed, and closing did not occur, until two days after the Hoensheids transferred the CSTC stock to the charitable organization. The court also disallowed the Hoensheids’ charitable contribution deduction because their appraisal report failed to meet the requirements of a qualified appraisal under Section 170. The claimed charitable contribution deduction was over $3 million.
On April 23, 2015, the Hoensheids and one of their suitors, HCI Equity Partners (“HCI”), executed a nonbinding letter of intent for the purchase of CSTC stock for $107 million. Between April 23rd and July 13, the parties negotiated the terms of a potential stock purchase agreement. During the same period, Mr. and Mrs. Hoensheid and their advisors worked on a gift of CSTC stock to Fidelity Charitable. The Hoensheids’ long-time tax and estate planning advisor, Andrea Kanski, advised Mr. and Mrs. Hoensheid their stock gifts should take place before there was any definitive agreement for the sale of CSTC stock. Mr. and Mrs. Hoensheid were reluctant to pull the trigger on their stock gift until they were virtually certain the stock sale to HCI would ultimately take place. From April 23 until July 15, negotiations between CSTC and HCI continued. During that period, Mr. and Mrs. Hoensheid continued to prepare the paperwork to complete the stock gift to Fidelity Charitable.
July 13, 2015, was a very busy day for everyone involved. At 4:38 a.m. the purchase agreement underwent a final redline comparison that confirmed the parties had finally agreed on the remaining open deal points. However, as of 9:13 a.m. on that same day, Fidelity Charitable had not yet received the physical stock certificate evidencing the shares’ transfer to Fidelity Charitable.
The Court considered whether the assignment of income doctrine caused the Hoensheids to recognize all the gain on the sale of the gifted CSTC shares. The court analyzed past cases addressing the elements that make a valid stock gift, such as (1) donative intent, (2) delivery of the gift and (3) acceptance of the gift. The court held Mr. and Mrs. Hoensheid did not relinquish dominion and control over the gifted shares until around 3:24 p.m. on the afternoon of July 13 when a PDF copy of the gifted stock certificate was emailed to Fidelity Charitable. The court concluded the delivery of the CSTC shares did not occur before July 13, and Fidelity Charitable likewise did not accept delivery of the gifted shares until later that day. That means July 13 was the date Mr. and Mrs. Hoensheid relinquished title to the CSTC shares. The court determined Mr. and Mrs. Hoensheid would never have made the gift but for the impending stock sale. The court noted when Fidelity Charitable received the shares, it had no legal obligation to sell them to HCI. On the other hand, when the Hoensheids transferred the stock to Fidelity Charitable, the sale was a virtual certainty.
Most important was no material unresolved sale contingencies remained when the shares were transferred to Fidelity Charitable on July 13. The email exchange between the parties at 4:38 a.m. included a redline comparison of the stock purchase agreement confirming all significant deal points had been resolved. Since there was no risk the sale would not occur when the contribution was made; the right to the income from the sale was fixed prior to the gift. Therefore, the Hoensheids were taxable on the sale proceeds received by Fidelity Charitable.
The court then disallowed the entire charitable contribution deduction because the stock appraisal was not a qualified appraisal meeting the requirements of Section 170(f)(11). There were several factors indicating the appraisal failed to meet the requirements of Treas. Reg. § 1.170A-13 (c)(3)), including it:
(1) did not include the statement that it was prepared for federal income tax purposes;
(2) included the incorrect date of June 11 as the date of gift;
(3) included a premature date of appraisal;
(4) did not sufficiently describe the method for the valuation;
(5) was not signed by the appraiser;
(6) did not include the appraiser’s qualifications as an appraiser;
(7) did not describe the gifted property in sufficient detail; and
(8) did not include an explanation of the specific basis for the valuation.
Mr. and Mrs. Hoensheid argued the appraisal report substantially complied with the Section 170 regulations. The court, however, found it did not. The appraiser’s biography in the report did not include the appraiser’s qualifications. The court found that fatal because the requirement that the appraisal be prepared by a qualified appraiser is one of the most substantive requirements in the regulations. See Mohamed vs. Commissioner, TC Memo 2012-152. Furthermore, the report contained an incorrect date of the contribution.
This was not a case, therefore, “where a taxpayer does all that is reasonably possible, but nonetheless fails to comply with the specific requirements of a provision.” Instead, the report was defective in that it failed to satisfy several substantive requirements, in addition to a number of minor defects, precluding a finding of substantial compliance.
The Hoensheids argued even though they were unable to establish substantial compliance, they should be allowed the charitable contribution deduction because they had reasonable cause for defective appraisal. Under the Section 170 regulations, taxpayers who fail to comply with the appraisal requirements may be entitled to a charitable contribution deduction if they show that their noncompliance is due to reasonable cause and not willful neglect. Section 170(f)(11)(A). Mr. and Mrs. Hoensheid argued they should be able to rely on their appraiser to perform an appraisal that met all of the substantiation requirements. They clearly established their long-term tax and estate planning advisor, Ms. Kanski, was an expert in her field. However, the IRS took the position it was Mr. and Mrs. Hoensheid, and not Ms. Kanski, who selected the appraiser, even though Ms. Kanski reviewed the appraisal, met with Mr. Dragon and advised Mr. and Mrs. Hoensheid about the Section 170 requirements of a qualified appraisal. Mr. and Mrs. Hoensheid should have known the appraisal report was defective on its face because the report showed a contribution date of June 11 rather than July 13. Because Mr. and Mrs. Hoensheid should have known the date of contribution, and thus the date of valuation, was incorrect, they could not rely on Ms. Kanski’s or Mr. Dragon’s judgment that the appraisal report contained the required information. Thus, Mr. and Mrs. Hoensheid did not have reasonable cause for their failure to procure a qualified appraisal.
In the penalty phase, the IRS conceded Mr. and Mrs. Hoensheid were not liable for the Section 6662(a) negligence penalty and the substantial understatement penalty relating to the disallowed charitable contribution deduction. Instead, the IRS argued there should be a new Section 6662(a) penalty assessed as to the underreported capital gains. The court ruled the IRS failed to meet its burden of establishing Mr. and Mrs. Hoensheid did not have reasonable cause for the underpayment of tax. Generally, the IRS bears the initial burden of production. It must produce sufficient evidence to establish a taxpayer is liable for negligence or understatement penalties. However, if a new penalty is asserted in an answer, the IRS carries the entire burden of proof to the new penalty assessment. The IRS would have to establish (1) Ms. Kanski was not a competent professional advisor; (2) Mr. and Mrs. Hoensheid failed to provide her with necessary and accurate information, or (3) that Mr. and Mrs. Hoensheid did not actually rely in good faith on her judgment. The court determined the IRS did not meet its initial burden of production since the court did not “consider the anticipatory assignment of income issue to be so clear-cut that Petitioners should have known it was unreasonable to rely on Ms. Kanski’s advice.” Therefore, no penalties were imposed.
V. Qualified Appraisal Required for Multiple Gifts to Goodwill and the Salvation Army; Bass v. Commissioner, TC Memo 2023-41.
During 2017, Mr. Bass donated significant amounts of clothing and other household items to Goodwill and the Salvation Army. Mr. Bass claimed he donated almost $14,000 of clothing to Goodwill and another $11,594 of clothing to the Salvation Army. Mr. Bass made regular trips to the Salvation Army and Goodwill, and sometimes made more than one trip a day. During 2017, Mr. Bass made 173 separate trips to Goodwill and the Salvation Army. Mr. Bass admitted he made numerous separate trips to avoid the requirement of having the donated items actually appraised. For each trip, Mr. Bass received from the Salvation Army or Goodwill worker a donation acknowledgment receipt he filled out listing the donated items and their estimated fair market values. Mr. Bass’ receipts showed he donated a total of $13,852 of clothing items to Goodwill and $11,594 of clothing items to the Salvation Army during 2017.
Mr. Bass claimed all of the donated clothing items as a Schedule A charitable contribution itemized deduction. However, he did not attach any qualified appraisal reports to his IRS Form 8283. Under the Section 170 regulations, for any non-cash charitable contributions exceeding $5,000, the donor is required to obtain a qualified appraisal for the contributed property.
Mr. Bass testified for each separate donation trip, the fair market value of his donated items was less than $250. He assumed, since each receipt for donated clothing showed a fair market value less than $250, he would not need to have any of the items appraised. However, under the Section 170 regulations, for purposes of determining whether donations for the year exceed the relevant $5,000 threshold, all similar items of property donated to one or more charitable organizations are treated as one property. Section 170(f)(11)(F) and Treas. Reg. § 1.170 A-13(c)(1)(i). The phrase “similar items of property” is defined as “property of the same generic category or type such as … clothing….” Treas. Reg. § 1.170 A-13(c)(7)(iii). Therefore, the court concluded, since Mr. Bass did not obtain a qualified appraisal for his clothing donations, he could not claim any charitable contribution deductions.
VI. Married Couple Failed to Qualify as Real Estate Professionals Because They Did Not Meet the More than One-Half Proportionality Test; Drocella vs. Commissioner, TC Summary Opinion 2023-12.
Mr. and Mrs. Drocella worked full-time for their regular employers during 2018. In addition, the Drocellas owned and managed six rental properties. Their real estate activities included renting and renovating the properties and handling issues with guests and tenants. The Drocellas kept logs of hours each of them individually spent on their real estate activities. Mr. Drocella’s time log showed he worked over 750 hours on the rental properties during 2018. Mrs. Drocella’s time log showed she spent less than 750 hours on the real estate activities. The Drocellas filed a Schedule E with their 2018 tax return showing a loss from real estate activities of $62,983. The Drocellas claimed their loss was not limited by the Section 469 passive activity loss limitation rules because they qualified as real estate professionals (“REPs”) who materially participated in their real estate activities.
The Tax Court noted in the case of a joint tax return, married taxpayers meet the REP requirements of Section 460(c)(7)(B) if either spouse separately satisfies all three of the REP requirements. However, to meet the 750 hours worked test, married taxpayers may not combine their hours. Instead, at least one of the spouses must meet the 750-hour test. For purposes of applying the proportionality test, a trade or business includes a taxpayer’s status as an employee. See Ostrom vs. Commissioner, TC Memo 2017-118 and Fowler vs. Commissioner, TC Memo 2022-223.
Both Mr. and Mrs. Drocella worked full-time for their regular employers. However, neither of them could provide the number of hours worked for their employers. Since neither Mr. Drocella nor Mrs. Drocella proved more than one-half of their total personal services performed in their trades and businesses were performed on their rental real estate activities, neither of them qualified as a real estate professional. It is not enough for taxpayers to prove the hours spent on their real estate activities. They must also prove the hours one of them worked for their regular employer did not exceed the hours worked on their real estate activities.
VII. Another Real Estate Investor Did Not Qualify as a Real Estate Professional Because He Did Not Prove His Hours Worked on Real Estate Activities; Teague vs. Commissioner, TC Summary Opinion 2023-16.
Mr. and Mrs. Teague owned four properties in Maine: a duplex and three cabins. For 2017 Mr. Teague worked full-time for Comcast. The Teagues claimed a $24,000 Schedule E loss on their rental real estate activities relating to all four of the Maine properties.
The IRS agreed the Maine cabins were a real estate activity in which the Teagues actively participated. However, because of the AGI phase-out limitations for active participation real estate activities, the Teagues were limited to deducting $1,500 of their $24,000. The Teagues, however, contended Mr. Teague qualified as a real estate professional, so the Teagues were entitled to the entire $24,000 loss. To determine whether Mr. Teague qualified as a real estate professional, the court had to consider: (1) the number of hours Mr. Teague worked at Comcast during 2017 and (2) the number of hours Mr. Teague worked on the rental properties during 2017. Mr. Teague worked as a full-time employee of Comcast. Mr. Teague gave inconsistent estimates of the amount of time he actually worked for Comcast. Since his testimony was not entirely credible, the court assumed Mr. Teague worked at least 1,840 hours in 2017 for Comcast (40 hours per week times 46 weeks). Therefore, Mr. Teague had to prove he worked at least 1,840 hours on his real estate activities.
Mr. and Mrs. Teague failed to keep records showing the time Mr. Teague spent working on the Maine cabins. Although Mr. Teague did not keep any specific logs, he claimed he spent 1,993 hours working on the cabins. The court noted the Teagues failed to group all four of the Maine properties as a single real estate activity on their 2017 tax return. Therefore, the time the Teagues spent working on the Maine duplex did not count for purposes of determining whether Mr. Teague qualified as a REP.
Mr. and Mrs. Teague also contended the hours spent by each of them should be aggregated for determining whether one of the Teagues qualified as a real estate professional. The requirements for a real estate professional are satisfied, however, only if either spouse separately meets the REP requirements. Section 469(c)(7)(B). Since Mr. Teague did not keep records of the amount of time spent working on the Maine cabins, the court made its own estimates based on Mr. Teague’s testimony. The court accepted Mr. Teague’s testimony he was physically at the cabins for 102 days during 2017. However, the court could not accept Mr. Teague’s claim he worked 12 hours per day on each of those 102 days, which would have totaled only 1,224 hours anyway. Mr. Teague provided details for around 300 of the total 1,224 hours he claimed to have worked at the cabins. Based on the lack of Mr. Teague’s records, the court concluded he did not meet his burden of proving he worked more than 1,840 hours at the Maine cabins during 2017.
VIII. Like-Kind Exchange Treatment Not Available for Certain Section 1245 Depreciation Recapture; Gerhardt vs. Commissioner, 160 TC No. 9.
A. Beware of special rules regarding depreciation recapture.
Depreciation recapture under Sections 1245 and 1250 is not eligible for Section 1031 tax-free exchange treatment. Complicated rules apply in determining the amount of depreciation recapture not eligible for Section 1031 treatment depending upon the nature of the real property involved and the year the property was placed in service. For example, for non-residential real property placed in service after 1980 and before 1987, all accelerated ACRS depreciation is subject to Section 1250 recapture. On the other hand, for residential real property, only the excess of ACRS depreciation over straight-line depreciation is subject to Section 1250 recapture.
B. Gerhardt v. Commissioner.
In Gerhardt, Jack and Shelley Gerhardt sold rental property located in Armstrong, Iowa in an attempted Section 1031 exchange. The rental property consisted of hog buildings and equipment, as well as land. Jack and Shelley treated the sale of the property as a Section 1031 exchange for replacement property located in Cape Coral.
The IRS did not challenge the exchange’s meeting the requirements of Section 1031. Instead, the IRS took the position a portion of the relinquished property consisted of Section 1245 property. Section 1245 property includes “property which is or has been property of a character subject to the allowance for depreciation provided in section 167” that is either (1) personal property or (2) a single-purpose agriculture or horticultural structure. Section 1245(a)(3)(A), (D). Under the Section 1245 regulations, if Section 1245 property is disposed of in a Section 1031 exchange, any gain from the disposition of the relinquished property may have to be recognized as ordinary income. Section 1245(a)(1) and (b)(4); Treas. Reg. § 1.1245-6(b). Moreover, if both Section 1245 property and non-Section 1245 property are disposed of in the same transaction, gain is allocated between the Section 1245 property and non-Section 1245 property in proportion to their respective fair market values. Treas. Reg. § 1.1245-1(a)(5).
The court found the hog buildings and equipment were Section 1245 property. Therefore, the gain on the sale of those assets did not qualify for Section 1031 exchange treatment. Moreover, Jack and Shelley did not present evidence of the fair market values of the non-Section 1245 property and the Section 1245 property. Since they did not establish how much of the gain from the sale of the Armstrong site could be allocable to non-Section 1245 assets, the court allocated all the gain to Section 1245 property, so none of the assets exchanged qualified for tax-free recognition under Section 1031.
Keith Wood is an attorney with Carruthers & Roth, P.A. in Greensboro, North Carolina