Federal Income Tax Update

By Keith A. Wood

I. Real Property Distributed from Testamentary Trust Meets the Section 1031 “Held for Investment” Requirement; PLR 202449007.

A testamentary trust terminated on the death of the decedent’s child. Real property held in the testamentary trust then passed to the decedent’s grandchildren. Prior to the trust termination, the trustees entered into a contract for the sale of the property and began to make arrangements for a deferred Section 1031 exchange of the property held in the trust. After the trust termination event, the trustees completed the sale of the property and sought a private letter ruling confirming the trust remainder beneficiaries (grandchildren of the decedent) would be permitted to complete like-kind exchanges as to their inherited real property.

The IRS ruled the trust’s previous purpose of holding the real property for investment purposes is imputed to the grandchildren notwithstanding the trustee’s planned sale at the time of the trust termination. The IRS emphasized, because the trust was a testamentary trust, the terminating event was fixed by the decedent and could not be modified or changed. The trust terminating event was an involuntary disposition of the trust’s real property. The transfer of the property to the grandchildren subject to the sales contract did not violate the held for investment requirement of Section 1031(a).

The IRS distinguished this PLR from Rev. Ruls. 75-292 and 77-337, which involved voluntary transfers of properties pursuant to a prearranged plan. In Rev. Rul. 75-292, an individual acquired real estate in a Section 1031 exchange and immediately transferred the real estate to a corporation in a Section 351 transaction. The IRS ruled the real estate was not acquired for investment purposes because of the immediate transfer to the corporation. The IRS held the corporation’s use of property in its business was not attributable to its sole shareholder.

In Rev. Rul. 77-377, the Service ruled the held for requirement was not met where an individual liquidated his corporation and then exchanged the corporation’s shopping center for other property. The IRS found the taxpayer did not acquire the shopping center for use in his trade or business because the corporation’s previous trade or business use was not attributed to its sole stockholder.

II. Conservation Easement Property was not Inventory in the Hands of the Donor; Jackson Crossroads, LLC vs. Commissioner, TC Memo 2024-111.

The IRS asserted several arguments to deny a conservation easement charitable deduction. First, the IRS argued the taxpayer’s appraisal failed to comply with qualified appraisal substantiation requirements under Section 170 because the taxpayer’s appraisers were disqualified. The IRS also argued the taxpayer’s charitable deduction was limited to its tax basis in the contributed property because the property constituted inventory in the hands of the donor. Finally, the IRS contended the appraisal grossly overstated the true fair market value of the conservation easement.

With respect to the qualified appraisal requirement, the IRS sought to disqualify the LLC’s appraiser. Although the appraiser met all the requirements of the Section 170 regulations, the IRS contended the appraisal nevertheless should be disqualified because the donor had “knowledge of the facts that would cause a reasonable person to expect the appraiser” to falsely overstate the value of the donated property.

In Oconee Landing Property, LLC, TC Memo 2024-25, the court determined an appraisal failed to meet the qualified appraisal requirement because the donor had already reached an implicit agreement with the appraiser as to the ultimate valuation. The donor understood the appraiser’s valuation would be substantially greater than what the donor knew to be the true value of the property. In Jackson Crossroads, however, the court found the taxpayer had no reason to expect that the appraiser would falsely overstate the value of the property nor was there any meeting of the minds on a predetermined value.

Next, the IRS argued the conservation easement property had been inventory in the hands of the partnership that distributed the property to the donor-taxpayer. Therefore, under the Section 724(b) five-year rule, the donor’s charitable deduction should be limited to its tax basis in the property under Section 170(e)(1)(A). The court applied the multi-factor test in Sanders vs. U.S., 740 F.2d 886 (11th Cir. 1984), and in Boree vs. Commissioner, 837 F.3d 1093 (11th Cir. 2016). It determined both the LLC and the contributing partner held the land primarily for conservation purposes and not as inventory. The court emphasized the LLC and the contributing partner both had shown the property on their balance sheets and tax returns as land and not as inventory.

The court, however, rejected the taxpayer’s valuations. It reduced the amount of the charitable contribution deduction from $37 million to $3 million and imposed a 40% valuation misstatement penalty.

III. Claims for both Physical Injuries as well as Violation of Constitutional Rights; Zajac v. Commissioner, TC Memo 2025-33.

Mr. Zajac was arrested for domestic violence against his wife. He alleged he suffered cuts and bruises as a result of the arresting officer’s use of excessive force. He also alleged that during his ride to the jailhouse, the arresting officer drove recklessly resulting in Mr. Zajac’s being tossed around. During his short jail stay in police custody, Mr. Zajac requested medical attention but did not receive any.

Mr. Zajac sued the police department claiming he suffered physical and emotional injuries as well as a violation of his constitutional rights. Mr. Zajac and the police department settled for $35,000. The parties executed a settlement agreement stating the $35,000 was made on account of the “accident, casualty or event which occurred on or about” Mr. Zajac’s arrest date. Mr. Zajac claimed the $35,000 was excludable under Section 104(a)(2).

The court stated the Section 104(a)(2) test concerns the intent of the payor and not that of the payee. In paying Mr. Zajac $35,000, the police department was settling all his claims, including those for physical and emotional injury as well as his constitutional claims. Therefore, at least some of the $35,000 resulted from the Police Department’s concerns about potential liability for Mr. Zajac’s physical injuries. Without more to go on, the court split the $35,000 award between Section 104(a)(2) exempt damages and nonexempt constitutional claims.

IV. Horse Enthusiasts Denied Hobby Loss Deductions for Horse Activities; Himmel vs. Commissioner, TC Memo 2025-35.

In Himmel, the Tax Court held the Himmels’ Arabian horse activities were not engaged in for profit. Various factors supported the IRS’s disallowance of the Himmel’s losses, including a long history of losses, their failure to establish and adhere to a business plan, their lack of efforts to reduce their expenses, minimal sales of horses, elements of personal pleasure and recreation, and their losses shielded other of taxable income.

In 1981, the Himmels began breeding, boarding, showing and training Arabian horses under a sole proprietorship called Plantation Arabians. The Himmels recorded losses from their activities at least as far back as 1993. The losses continued during the 2004 through 2009 years under audit. The Himmels became friends and exchanged industry know-how with fellow breeders and trainers whom they met at horse shows. One of their friends, Mr. Dearth, successfully bred Arabian horses for over forty years. Mr. Dearth shared his business model with the Himmels, but encouraged them to operate on a much smaller scale.

The court concluded the Himmels did not operate their horse activities with an honest and objective intent of making a profit. The court considered the following factors:

1. Books and Records. The Himmels maintained a separate checking account for Plantation Arabians and used QuickBooks to record most of their income and expenses on a daily basis. The Himmels also prepared quarterly financial reports. Although the Himmels maintained complete and accurate books and records, they did so primarily for tax reporting purposes rather than to cut expenses, increase profits, and evaluate the overall performance of their operations.
2. Business Plans. Although the Himmels never had a written business plan for Plantation Arabians, they had an informal business plan. Nevertheless, the court determined the primary purpose of their informal business plan was to track income and expenses for tax reporting purposes. The Himmels never took any action to modify their plan to reduce expenses and never prepared profit plans or financial projections.
3. Comparable Activities. In contrast to other horse producers like Mr. Dearth, the Himmels failed to dispose of horses to trim expenses or enhance profitability. Through 2009, the Himmels only sold two horses in fourteen years.
4. Changing Operational Procedures to Improve Profitability. The Himmels claimed they changed certain aspects of their operations to improve profitability, such as cultivating hay to cut feeding expenses. However, the Himmels undertook that change prior to the years at issue. That change, therefore, was not made to improve profitability during the audited years.
5. Expertise of the Taxpayer or its Advisors. The Himmels argued they relied on Mr. Dreath’s advice in running their horse farm. However, the Himmels did not meet Mr. Dearth until 1991. That was a decade after they began operating Plantation Arabians and not during their initial investigation stages prior to beginning their horse operations.
6. Expectation that the Property Used in the Activity Would Appreciate in Value. The Himmels operated their activities on a property they purchased for $125,000, on which they then built a 900 sq. ft. residence as well as a 4,000 sq. ft. barn with 10 stalls. The Himmels maintained the value of their property had appreciated to over $550,000 by December 2009. They contended, as demonstrated by the farm valuations in 2009, they fully expected their property to appreciate. However, the Himmels did not demonstrate how much of the appreciation was attributable to their personal residence. Since the valuations included their personal residence, the court could not determine the appreciation in the Plantation Arabians’ property.
7. Time and Effort Devoted to the Activity. The Himmels performed most of the activities at their farm themselves. They spent significant hours engaging in unpleasant activities of horse farming such as mucking stalls, grooming, feeding and watering their horses.
8. Elements of Personal Recreational Pleasure. The Himmels readily admitted they loved Arabian horses and enjoyed training and showing horses. The Himmels personally benefited from developing relationships and friendships with fellow horse enthusiasts. That further supported the IRS’s contention that there was a significant element of personal recreational pleasure.
9. Taxpayer’s Financial Status. The Himmels had only modest taxable income from other activities. Section 183, however, does not apply only to wealthy individuals. Even taxpayers with modest tax liabilities can have a motive to shelter their income with hobby losses.

Keith Wood is an attorney with Carruthers & Roth, P.A. in Greensboro, North Carolina.