TAX COURT OPINION

Case: Jay Daryl Wahlin & Kristine M. Wahlin
Docket Number: 23108-16S
Judge: Leyden
Opinion Type: bench
Filed: 02/23/2018
Pages: 13

RS UNITED STATES TAX COURT WASHINGTON, DC 20217 JAY DARYL WAHLIN & KRISTINE M. WAHLIN, Petitioners, v. ) ) ) ) ) Docket No. 23108-16S. COMMISSIONER OF INTERNAL REVENUE, Respondent ) ) ) ORDER Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit herewith to Petitioner and to respondent a copy of the pages of the transcript of the trial in the above case before Special Trial Judge Diana L. Leyden at San Diego, California, on January 31, 2018, containing her oral findings of fact and opinion rendered at the conclusion of the trial. In accordance with the oral findings of fact and opinion, decision will be entered under Rule 155. (Signed) Diana L. Leyden Special Trial Judge Dated: Washington, D.C. February 23, 2018 SERVED Feb 26 2018 Bench Opinion by Special Trial Judge Diana L. Leyden January 31, 2018 Jay Daryl Wahlin and Kristine M. Wahlin v. Commissioner of 3 Internal Revenue Docket No. 23108-16S THE COURT: THE COURT HAS DECIDED TO RENDER ORAL FINDINGS OF FACT AND OPINION IN THIS CASE, AND THE FOLLOWING REPRESENTS THE COURT'S ORAL FINDINGS OF FACT AND OPINION. THE ORAL FINDINGS OF FACT AND OPINION SHALL NOT BE RELIED UPON AS PRECEDENT IN ANY OTHER CASE. See Rule 152(c), Tax Court Rules of Practice and Procedure. This proceeding was heard as a Small Tax Case pursuant to the provisions of section 7463 of the Internal Revenue Code of 1986, as amended, and Rules 170 through 175 of the Tax Court Rules of Practice and Procedure. This bench opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court Rules of Practice and Procedure. Hereinafter in this bench opinion, all section references are to the Internal Revenue Code, as amended and in effect for the relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure. The Court uses the term "IRS" to refer to 1 2 G 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 1 2 3 4 5 6 7 8 9 10 11 12 administrative actions taken outside of these proceedings. The Court uses the term "respondent" to refer to the Commissioner of Internal Revenue, who is the head of the IRS and is respondent in this case, and to refer to actions taken in connection with this case. The trial of this case was conducted on January 29, 2018, in San Diego, California. Petitioner husband appeared on petitioners' behalf. Monica Polo appeared on behalf of respondent. In a notice of deficiency dated August 1, 2016, the IRS determined a deficiency in petitioners' 2013 Federal income tax of $34,690 and a section 6662(a) 13 accuracy-related penalty of $6,938. At trial respondent 14 15 conceded that the IRS had not asserted the accuracy- related penalty on the basis of negligence or intentional 16 disregard of the rules and regulation. 17 18 19 The only issues for decision by the Court are: (1) whether petitioners may claim a deduction for interest on Schedule E, Supplemental Income and Loss, and (2) 20 whether petitioners are liable for the accuracy-related 21 penalty under section 6662(a) and (b)(2) for 2013. 22 Background 23 24 25 Some of the facts are stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioners (973)406-2250|operationseescribersnet|www.escribers.net resided in the State of California at the time that the petition was filed with the Court. Petitioner husband is a certified public accountant and has been such for 44 5 years. In 2005, petitioners purchased the following three rental properties in Palm Desert, California: (1) 73-330 Santa Rosa Way (Santa Rosa property), (2) 73-331 Fred Waring Drive (73-331 Fred Waring property), and (3) 73-341 Fred Waring Drive (73-341 Fred Waring property). To purchase the properties, petitioners obtained a loan for each property from Countrywide Bank (Countrywide) and secured the loans with the properties. On June 24, 2005, 1 2 3 4 5 6 7 8 9 10 11 12 13 petitioners executed three adjustable rate notes for the 14 following principal amounts: (1) $316,500 for the Santa 15 Rosa property, (2) $307,500 for the 73-331 Fred Waring 16 property, and (3) $319,500 for the 73-341 Fred Waring / 17 property. The etitioners executed an adjustable rate 18 19 note for each of the principal amounts borrowed on June 24, 2005. These notes provided for negative interest 20 amortization, which meant that by signing the adjustable 21 rate notes petitioners agreed that their monthly payments 22 would be less than the interest due under the notes and Mndr pke Countrywide would add the difference to the unpaid 23 24 principal. Thus, the amount of the principal would 25 increase from the initial amount borrowed. (973)406-2250|operationspescribers.net|www.escribers.net 6 In 2009 Countrywide contacted petitioners and offered a modification of the adjus d rate notes. Petitioners applied for a modification of each note and, as a result, were required to pay only interest for ten years. After ten years, the rate under the notes would change and petitioners would be required to start paying the then-principal amount through monthly payments. As of April 20, 2009, after the modifications, the outstanding principal for each modified note was: (1) $348,516.38 for the Santa Rosa property, (2) $338,605.74 for the 73-331 Fred Waring property, and (3) $351,819.49 for the 73-341 Fred Waring property. Shortly after the modifications, the Bank of America acquired Countrywide and became the lender on the notes. On January 31, 2013, petitioners sold the 73-331 Fred Waring property in a short sale for $100,000. The purchaser issued a 2013 Form 1099-S, Proceeds from Real 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Estate Transactions, to petitioners and reported the 19 $100,000 as gross proceeds from the sale. Petitioners 20 paid the $100,000 to Bank of America in &a±± satisfaction 21 of the outstanding note on the 73-331 Fred Waring 22 property. Bank of America issued a 2013 Form 1099-C, 23 Cancellation of Debt, for that note and reported 24 25 $246,328.48 as the amount of debt discharged and zero as the amount of interest included in the discharged debt. (973) 406-2250| ope,ationseescr ibers.net j www.escribers.net 7 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Bank of America did not issue a 2013 Form 1098, Mortgage Interest Statement, to petitioners with respect to the 73-331 Fred Waring property note. On January 31, 2013, petitioners sold the 73-341 Fred Waring property in a short sale for $110,000, for which the purchaser issued a 2013 Form 1099-S reporting the $110,000 as gross proceeds from the sale. Petitioners paid Bank of America the $110,000 in fuìì satisfaction of the outstanding note on the 73-341 Fred Waring property. Bank of America issued a 2013 Form 1099-C for that note and reported $250,233.22 as the amount of debt discharged and zero as the amount of interest included in the discharged debt. Bank of America did not issue a 2013 Form 1098 to petitioners with respect to the 73-341 Fred 15 Waring property note. 16 On March 19, 2013, petitioners sold the Santa 17 Rose property in a short sale for $100,000. The purchaser 18 19 issued a 2013 Form 1099-S to petitioners and reported gross proceeds from the sale of $100,000. Petitioners 20 paid Bank of America the $100,000 in fu44-satisfaction of 21 the outstanding note on the Santa Rosa property. Bank of 22 America issued a 2013 Form 1099-C for that note and 23 reported $256,551.25 as the amount of debt discharged and 124 zero as the amount of interest included in the discharged 25 debt. Bank of America did not issue a 2013 Form 1098 to (973)406-2250|operationsgescrbersnetj www.esenbers.net 8 1 2 3 4 5 6 7 8 9 10 11 petitioners with respect to the Santa Rosa property note. Petitioners timely filed their 2013 Federal individual income tax return, after requesting an extension. On the Schedule E attached to their 2013 tax return, petitioners reported the following as mortgage interest paid with respect to their three properties: (1) $40,525 for the 73-341 Fred Waring property and (2) a combined amount of $79,658 for the 73-331 Fred Waring property and the Santa Rosa property. At trial petitioner husband asserted revised amounts of mortgage interest paid (1) for the 73- Fred Waring property of $32,175 and (2) 12 a combined amount of $62,976 for the 73-331 Fred Waring 13 property and Santa Rosa property. Petitioners filed a 14 15 16 17 18 19 20 21 Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), and claimed an election under section 108(b)(5) to reduce the basis of the depreciable property in the amount of $753,112. The IRS examined petitioners' 2013 tax return and disallowed the reported mortgage interest paid with respect to petitioners' three rental properties. The IRS 22. also determined that petitioners were liable for the 23 accuracy-related penalty under section 6662(a). The 24 asserted penalty was approved by a manager. 25 Discussion (973)406-2250|operations escribers.netlwww.escnbers.net 9 Generally, the Commissioner's determination of a deficiency is presumed correct, and the taxpayer bears the burden of proving it incorrect. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Moreover, deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any deduction claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). 1 2 3 4 5 6 7 8 9 10 Under section 7491(a), the burden of proof may 11 shift to the Commissioner if the taxpayer produces 12 13 14 15 credible evidence with respect to any relevant factual issue and meets other requirements. Petitioners have not argued that section 7491(a) applies nor established that its requirements are met. The burden of proof remains 16 with petitioners. 17 18 A. Section 163 Interest Deduction Section 163(a) allows a taxpayer a deduction for 19 all interest paid or accrued within the taxable year on 20 21 22 indebtedness. It is well settled that cash method taxpayers, such as petitioners, are allowed a deduction for interest paid in cash or its equivalent during the 23 taxable year in which it is paid. Davison v. 24 Commissioner, 107 T.C. 35, 41 (1996), aff'd, 141 F.3d 403 25 (2d Cir. 1998); Menz v. Commissioner, 80 T.C. 1174, 1185 BElE!HI (973)406-2250|operationsøescsbers.net|wur.esedbers.net 10 1 2 3 4 5 6 7 8 9 10 11 (1983). When a lender debits the required interest payment to a loan account (i.e., capitalizing the required interest payment by adding it to-i--t-s--ametm-t----bo the loan's principal), a cash method borrower is not entitled to a current interest deduction for the interest debited. Heyman v. Commissioner, 70 T.C. 482, 485-487 (1978), aff'd without published opinion, 633 F.2d 215 (6th Cir. 1980); Rubnitz v. Commissioner, 67 T.C. 621, 627-628 (1977). The notes allowed the lenders (first Countrywide and then Bank of America) to add the unpaid interest to the principal, which they did in fact do. Starting in 12 November 2012 and until the properties were sold 13 petitioners did not pay any interest on the notes. When 14 petitioners sold the properties, the proceeds from the 15 16 short sales went to Bank of America, the then-holder of the notes. Nothing in the record shows that Bank of 17 America applied any of the proceeds to deferred or unpaid 18 19 20 21 22 interest. In fact, the amounts listed as discharged debts on the Forms 1099-C issued by bhe Bank of America equal the then-unpaid principal amounts under the three notes reduced by the payments from the proceeds from the short sales. Thus petitioners have not proven that any of the 23 payments from the proceeds received from the short sales 24 were applied by Bank of America to pay interest. In fact, 25 Bank of America did not issue Forms 1098, which it would (973)406-2250|operationspescrbers.netlwww.escribers.net 11 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 have been required to do if any of the payments were applied to deferred or unpaid interest for 2013. Petitioner husband argued that as a matter of accounting, Bank of America should have accounted for the deferred interest by applying a portion of the payments to the deferred interest on each note. As the Court explained during the trial in this case, what Bank of America may have been required to do for accounting purposes does not control whether petitioners are allowed a deduction for Federal income tax purposes. NUt-TrìTrg-rn the record, or bw-bhe petitioner husband's testimony, supports petitioners' assertion that they were entitled to claim a deduction for deferred interest with.respect to any of the three rental properties for 2013. Petitioner husband at trial argued that a reported opinion by the United States District Court for the Southern District of California supports petitioners' claim that they are entitled to a deduction for deferred interest for 2013. See Horn v. Bank of America, N.A., No. 20 3:12 cv-1718-GPC-BLM, 2014 U.S. Dist. LEXIS 51972 (S.D. 21 Cal. 2014). Petitioners' reliance on Horn is misplaced. 22 Horn discusses a settlement between a class of plaintiffs, 23 24 of which petitioners were not part, and Bank of America. Bank of America confirmed in a letter dated 25 October 11, 2017, that petitioners were excluded from the EM (973)406-2250|operationseescribers.net|www.escribers.net 12 1 2 3 4 5 6 7 8 9 class action lawsuit in Horn and that their unpaid deferred interest was converted into principal debt when the Countrywide notes were modified. In that same letter, Bank of America informed petitioners that "Current I.R.S. guidance provides that after we modified the mortgages, the original mortgages were extinguished and replaced by new, modified mortgages. The I.R.S. Form 1098 reporting requirements only requires us to report on Form 1098 a customer's payments of interest that accrued on the loan 10 after the modification." 11 12 The Court holds that petitioners have not met their burden of proof and have failed to show that they 13 were entitled to deduct either the amounts reported as 14 mortgage interest paid on the Schedule E with respect to 15 16 17 18 19 the three properties or the revised amounts of mortgage interest paid petitioners asserted at trial. B. Accuracy-Related Penalty Section 6662(a) and (b)(2) provides an accuracy- related penalty equal to 20% of the portion of an 20 underpayment attributable to any substantial 21 understatement of income tax. Under section 7491(c), the 22 Commissioner bears the burden of production with regard to 23 penalties. Higbee v. Commissioner, 116 T.C. 438, 446 24 25 (2001). To meet that burden, the Commissioner must come forward with evidence indicating that it is appropriate to ) Em 973)406-2250|operations@erribers.net|www.esctfbersnet 13 1 2 3 4 5 6 7 8 9 10 11 12 impose a penalty. Id. The Court concludes that respondent has met his burden of production with respect to a substantial understatement of income tax under section 6662(b)(2). Respondent has also presented evidence that the section 6662(a) penalty was "personally approved (in writing) by the immediate supervisor of the individual making such determination." See sec. 6751(b)(1); Chai v. Commissioner, 851 F.3d 190, 221 (2nd Cir. 2017), aff'g in part, rev'g in part T.C. Memo 2015- 42; Graev v. Commissioner, 149 T.C. , (slip op. at 14) (Dec. 20, 2017). Although respondent bears the burden of 13 production with respect to accuracy-related penalty 14 15 determined for 2013, respondent "need not introduce evidence regarding reasonable cause, substantial 16 authority, or similar provisions * * * [because 17 petitioner] bears the burden of proof with regard to those 18 19 20 21 issues." Higbee v. Commissioner, 116 T.C. at 446. A penalty will not be imposed under section 6662(a) if the taxpayer establishes he acted with reasonable cause and in good faith. Sec. 6664(c)(1). 22. Circumstances that indicate reasonable cause and good 23 24 25 faith include reliance on the advice of a tax professional or an honest misunderstanding of the law that is reasonable in light of all facts and circumstances. Sec. (973)406-2250|operations@escribers.netlwww.escribers.net 1 2 3 4 5 6 7 8 9 1.6664-4(b), Income Tax Regs.; see Higbee v. Commissioner, 116 T.C. at 449. Relevant factors for the Court to consider include the knowledge and experience of the taxpayer. Sec. 1.6664-4(b) (1), Income Tax Regs. Petitioner husband credibly testified that at the time petitioners filed their 2013 tax return the Horn decision had been decided and that petitioners believed that the basis of the settlement in that case would apply to their situation. Bank of America's letter informing 10 petitioners of the contrary was not sent until October 11, 11 12 13 2017. The Court concludes that petitioners had reasonable cause for reporting the deferred interest as mortgage interest paid. Therefore, the Court concludes that 14 petitioners are not liable for the accuracy-related 15 penalty for 2013. 16 17 In order to give effect to our disposition of the disputed issues, decision will be entered for under 18 Rule 155. 19 THIS CONCLUDES THE COURT'S ORAL FINDINGS OF FACT 20 AND OPINION IN THIS CASE. (Whereupon, at 9:57 a.m., the above-entitled matter was concluded.) 21 22 23 24 25 73)406-2250|operationseescribers.net]www.escribers.net