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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Monday, March 19, 2018

Lesson From The Tax Court: The Turbo-Tax Defense

Turbo TaxDespite the adage “ignorance of the law is no excuse,” the Tax Court issued an opinion last week suggesting that sometimes ignorance of the tax law can indeed be an excuse, at least to escape the §6662 accuracy-related penalties.   In Karl F. Simonsen and Christina M. Simonsen v. Commissioner, 150 T.C. No. 8 (Mar. 14, 2018), the Tax Court held that a California couple who messed up the tax treatment of a short sale of their former residence were not liable for accuracy-related penalties. Judge Mark “I’m No Caligula” Holmes wrote for the Court. The actual basis for the holding was that the IRS “failed to meet [its] burden of production on the accuracy-related penalty” because it did not introduce any evidence of compliance per the Tax Court’s newly discovered reading of §6751(b)(1). Our colleagues over at Procedurally Taxing have been following the §6751 issue for some time. If you are interested, here’s a good post by Professor T. Keith Fogg to start you out.

But immediately after throwing out the penalty for the IRS’s failure to produce the required evidence, Judge Holmes wrote four pages of dicta about how even if the IRS had met its burden, the taxpayers here acted with “reasonable cause and in good faith” within the meaning of the exculpatory language of §6664(c)(1). Why did he spend so much time doing this? Because he wanted the world to know that “we will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance.” And one of the factors that went into the “good faith” conclusion was that Mrs. Simonsen not only consistently used TurboTax for over 11 years to prepare the couple’s returns, but had to upgrade to “a CD-ROM version of TurboTax instead of the usual online version because she needed a special form...to properly report the...income.” That caused my colleague Gregg Polsky to email me with this query: “So this case means that taxpayers that follow Turbo Tax to a completely illogical result are immune from penalties?”

Well, maybe...but then again remember this is just dicta. And while the Tax Court is correct that tax is a “complicated subject area” I do not think it was correct in finding that the taxpayers here had no “clear guidance.” But reasonable minds may disagree.

Along with the penalty lesson, this case teaches a nice lesson on the tax treatment of a short sale of property encumbered with a non-recourse loan.  I’ll run through that first because it may help us understand why the Tax Court here was willing to let ignorance of the law be a defense to accuracy-related penalties.

Details below the fold.

In July 2005, Mr. and Mrs. Simonsen bought a home in San Jose, California, for about $695,000. They obtained a purchase money loan from Wells Fargo for 80% of the purchase price. When the Great Recession hit in 2008, the home’s value went South. In 2010, so did the Simonsens, moving out of the home.

Since they were underwater on the home when they moved out, they decided to rent it out. The act of renting converted their home from being their principal residence to being a “property held for the production of income” within the meaning of §212.  That meant they could take deductions for the carrying costs, depreciation, and upkeep against any rental income they received. But it did not necessarily mean they could take a §165 loss deduction on a subsequent sale of the home. The classic case on just this point (effect of conversion on §212 and §165 deductions) is Horrman v. Commissioner, 17 T.C. 903 (1951)(allowing §212 deductions for carrying costs but denying §165 loss deductions for loss on sale subsequent to conversion). Allan J. Samansky wrote this still-useful law review article that gives a more comprehensive treatment of the subject.

At the time the Simonsens started renting out their former home, everyone agreed it’s fair market value was $495,000. The Simonsens rented out their property for one year and reduced their basis by some $115,000. Don’t ask me where they got the $115,000 from.  It did not seem to be an issue in the case.  In 2011 they sold the property for $363,000, which was less than what they owed on the mortgage, which had a balance of $556,000 at that time.  That’s called a “short sale” because after the sale they were still some $219,000 short on repaying the mortgage. Under California law, Wells Fargo was not permitted to recover the unpaid balance of the mortgage from the Simonsens. It could only take the proceeds of the sale. In other words, Wells Fargo had no recourse against the Simonsens for the balance of the mortgage. So Wells Fargo sent the Simonsens a Form 1099-C “Cancellation of Debt” (“COD”) to reflect that it was cancelling the remaining balance of some $219,000 on their mortgage.

Here are those numbers again. Believe me, you will need to come back and look at them.

2005 Purchase price: $695k.

2010 fair market value at date of conversion: $495k.
2010-2011 Depreciation: $115k.

2011 sales price: $363k.
2011 loan balance at date of sale: $556k.
2011 adjusted basis: $580k.
Costs of sale: $26k.

COD reported on 1099-C: $219k.

On their 2011 return, the Simonsens decided to report a deductible loss of $216k on the sale, and also decided they could use §108 to exclude the reported $219k COD. I have no idea how they got the §216k loss from the other numbers reported in the decision. But it does not matter; the real issue in the case is whether they were correct to treat the sale and the COD as separate transactions. Put differently, they knew they had a sale of property and needed to figure their gain or loss on that sale. The question is whether the COD was part of that sale or a separate transaction.

The proper tax treatment of the Simonsens’ 2011 property transaction is not really that hard to figure out. It’s the sale of property. Section 1001 says that to figure out the gain or loss from the sale of property, one needs to know two numbers: the “amount realized” (AR) and “the adjusted basis" (AB). One subtracts the adjusted basis in the property from the amount realized from the sale to report either a gain or loss.

When COD is involved, the computation gets a bit trickier but, still, the regulations give good guidance. They explain that the nature of the debt as recourse or non-recourse affects the AR number. Specifically, Treas. Reg. 1.1001-2(a)(1) (“Discharge of Liabilities”) says that “except as provided in paragraph (a)(2) and (3) of this section, the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged.” Paragraph (a)(2) says that if the discharged loan was recourse, then the discharged amount is treated as COD and is not part of the AR. Paragraph (a)(3) says that if the discharged loan was used to acquire the property sold but is not put into the seller’s basis, then the discharged amount is, again, not part of the AR.

Since the 1930’s California state law has included what is now codified as California Code of Civil Procedure §580b, a statute that makes purchase money home loans issued to purchase homes non-recourse.  For those interested, the California Bar Association gives a nice summary and history of that statute as part of its 2011 recommendation to expand non-recourse treatment to re-fi’s.

So as applied to the Simonsens, since their debt was non-recourse debt, the regulations tell them that the amount of debt discharged is part of the AR on sale of the home and is not COD. That means their AR in 2011 was $530k (the loan balance of $556k less the costs of sale of $26k).

So that’s the amount realized. What about the adjusted basis (AB)? Well, if the Simonsens had not rented out the property, this would be easy. It would be the amount they paid for the home plus the cost of any capital improvements they made. But just as discharge of debt makes figuring the amount realized trickier, conversion of the home to a rental property creates two complications in figuring the AB.

The first complication is that the Simonsens needed to account for depreciation. Section 1016 says they must adjust their basis by the greater of the amount of depreciation they actually took or that would have been allowable. It appears they took $115k in depreciation. I confess I am befuddled about where the $115,000 came from (I get that number from page 6 of the opinion where Judge Holmes says they used “their converted adjusted basis (reduced by depreciation) in the townhouse, $579,495”). But let’s go with it because, as we shall soon see, the second complication makes it irrelevant.

The second complication comes from §165. That’s the section that allows taxpayers to take a loss incurred in either a “trade or business” or “transaction entered into for profit.” Assuming for the moment that the rental activity fit into one of those categories, the regulations give a special rule for how taxpayers just like the Simonsens must compute a loss from the sale of property that was converted from personal residential use to rental use. Treas. Reg. 1.165-9(b) says that for purposes of calculating a loss of that kind of property, taxpayers must use the lesser of two numbers as their starting basis (before adjusting downwards for depreciation per §1016): (1) the taxpayer’s basis in the property at the date of conversion to rental use; or (2) the property’s fair market value at date of conversion. If one does not have a loss, one computes the gain by simply using the first number.

Applying that regulation here shows the first number to be $695k and the second number to be $495k. (Here is where you want to go review those numbers!). The lesser of those numbers is the $495k. Adjusting that for the $115k depreciation gives us an adjusted basis of $380k.

Wait. Stop. Subtracting this $380k basis from the amount realized of $530k yields a positive number, not a loss. But the rule in Treas. Reg. 1.165-9(b) is only for purposes of calculating a loss. Taxpayers who have a gain just use their basis in property at date of conversion (then adjust for depreciation). Here, however, that would produce an adjusted basis of $580k. That would result in a loss! But the rule in Treas. Reg. 1.165-9(b) says you can only use the basis in the property at date of conversion to calculate a loss if it is less than the fair market value of the property on the date of conversion.

So you cannot report either a gain or a loss. And that’s the tax result from the sale of the home. Zippo. There is no gain to report. There is no loss to report. There is nothing to report.

IRS publication 544 explains all this pretty well. Here’s how it describes the rules in Treas. Reg. 1.165-9(b):

"You can deduct a loss on the sale of property you acquired for use as your home but changed to business or rental property and used as business or rental property at the time of sale. However, if the adjusted basis of the property at the time of the change was more than its fair market value, the loss you can deduct is limited. Figure the loss you can deduct as follows: 1. Use the lesser of the property's adjusted basis or fair market value at the time of the change. 2. Add to (1) the cost of any improvements and other increases to basis since the change. 3. Subtract from (2) depreciation and any other decreases to basis since the change. 4. Subtract the amount you realized on the sale from the result in (3). If the amount you realized is more than the result in (3), treat this result as zero. The result in (4) is the loss you can deduct."  (Emphasis supplied)

Notice the instruction: “treat this result as zero.” That means you do not report a gain. You do not report a loss. Nothing to report here.

Instead of following the guidance in Treas. Reg. 1.1001-2, Treas. Reg. 1.165-9, and IRS Publication 544, Mrs. Simonsen (who prepared their 2011 tax return) decided to treat the sale of the former home separately from the COD. That led her to try and find an exclusion for the COD income and she turned to §108 and the guidance there and got lost in the weeds. For some reason the Tax Court spends a lot of time rambling around in those same weeds. I would be grateful if someone can explain why §108 has anything to do with the proper resolution of this case. Perhaps I should be subject to accuracy-related penalties for missing something obvious!

So that is the substantive tax lesson: whether a short sale where the unpaid debt is discharged is one transaction or two for tax purposes depends if the debt being discharged is recourse or non-recourse.  

Now for the penalty lesson.

The §6662 accuracy related penalty is not a consequence for being bad. It’s a consequence for being inaccurate. Here the taxpayers were inaccurate to the tune of $70,000 in under-reported taxes.  Still, §6664(c) gives a “reasonable cause” escape hatch for those taxpayers who show they made a demonstrable effort to get it right. Here, most of the facts recited by Judge Holmes to show how Mrs. Simonsen made a demonstrable effort to get it right seem to relate to Mrs. Simonsen’s attempt to use §108. The one single fact that Judge Holmes recites that relates to her fundamental error in treating the sale as two transactions instead of one was that she received both a 1099-C from Wells Fargo and a 1099-S from the title company. Judge Holmes, however, admits that the Form 1099-C directs taxpayers to consult IRS publication 4681 (“Canceled Debts, Foreclosures, Repossessions, and Abandonment”). And when you read that publication you will see that it consistently distinguishes between recourse debt and non-recourse debt, including this paragraph:

"However, upon the disposition of the property securing a nonrecourse debt, the amount realized includes the entire unpaid amount of the debt, not just the FMV of the property. As a result, you may realize a gain or loss if the outstanding debt immediately before the disposition is more or less than your adjusted basis in the property. For more details on figuring your gain or loss, see chapter 2 of this publication or see Pub. 544, Sales and Other Dispositions of Assets."

It just seems to me that the error committed by the taxpayers here was a pretty simple one: they treat the sale and COD as two transactions and not one.  The guidance on that question is not a tortured path.  It’s not a big mystery.  Heck, they could have Googled something like this: “California Law Tax Issues Foreclosure Short Sales.” I don’t know what would have come up in 2011, but one of the top three hits on Google is this webpage from a California tax attorney that has a good discussion of the difference between tax treatment of recourse debt (two transactions) and non-recourse debt (one transaction).  I don't know if this webpage was around in 2011, but he looks like he may have been around then.  And there were plenty of others to ask as well.     

But the point is that Mrs. Simonsen did not even seem to try that basic search. The taxpayers here made no demonstrable effort to find the right path.  And while Turbo Tax does an "interview" you cannot ask the program questions.  Mrs. Simonsen did not seek professional help and her self-help efforts went badly awry when she simply ignored that, as has been true since the 1930's, purchase money home loans in California are non-recourse. Keep in mind as well that Mrs. Simonsen received a J.D. from Loyola Law School in L.A. So you would think she would know California property law.  Instead, she relied on Turbo Tax to tell her to report the sale and COD as two transactions and so she went hopping down an irrelevant rabbit trail.  Those are her efforts that the Court seems to think excuse her inaccurate reporting of the short sale and inaccuracy that resulted in a $70,000 understatement of tax.     

So did the Turbo Tax defense work here?  No.  Remember, it's just dicta.  Yes.  The Court goes to great lengths to explain that it would have excused the taxpayer from penalties and her use of Turbo Tax formed a significant part of her compliance efforts.  Heck, maybe that means you, or your clients, can get away with it, too.  What's the worst that can happen?    

Coda: Throughout his opinion, Judge Holmes conflates the statutory term “Discharge of Indebtedness” (DOI) with it’s commonly used alternative “Cancellation of Debt” (COD) to create a new acronym: Cancellation of Indebtedness (COI).  I don't know where this new acronym came from.  If one does not want to use the statutory acronym DOI, one can use COD, which is the term used by most practitioners and the IRS on its Form 1099-C. Lord knows we have too many acronyms already without introducing a new one. It’s not clear what the purpose is of creating yet another acronym in this area except maybe to create more confusion...and so give taxpayers more opportunity to claim they made a demonstrable effort to get the law right! ICWYDT, Judge Holmes.

https://taxprof.typepad.com/taxprof_blog/2018/03/lesson-from-the-tax-court-the-turbo-tax-defense.html

Bryan Camp, New Cases, Tax | Permalink

Comments

Maybe the judge realized that Mr. Simonsen was neither an attorney or CPA. This is another example of why the code should be simplified.

Posted by: Johnny | Mar 19, 2018 7:05:34 AM

The factual issue of two transactions versus one transaction matters for nonrecourse debt. If it is one transaction, the entire nonrecourse debt is included in amount realized. If it is two transactions (first, a reduction of NR debt and second, a sale of the property), the first transaction results in COD income and the second's amount realized includes only the reduced NR debt balance.
With regard to recourse debt, in a short sale (where the lender agrees to waive the deficiency), the transaction will always be treated for tax purposes as two steps: a reduction of debt (resulting in COD income) and a sale for the FMV of the property.
Judge Holmes was getting at the first issue--the factual question of whether there was an independent debt reduction. I think he was right, but he made the issue seem much more difficult than it was--the lender never agreed to simply reduce the loan balance; the lender agreed to the short sale. And, as Bryan mentions, the opinion is kind of a mess in other ways--the whole discussion of COD income is irrelevant because this was clearly one transaction and clearly NR debt. Even if Judge Holmes was trying to be complete in considering other arguments (which seems to be to be unnecessary given that the issue is a slam dunk), he never even completed the discussion of what would happen if there was COD (or COI) income! He got hung up on the principal residence issue and never determined whether the COD income was excluded (which was another case of unnecessary hand wringing; they moved out of the property to a new principal residence).
By overcomplicating the substantive tax issue (which should have been disposed of in a few pages), Judge Holmes buried the fact that the taxpayer was claiming a double tax benefit: she was claiming that the purported excluded COD income was both excluded and also gave her basis, which caused the loss she claimed. Even if the governing tax law was complicated, the double tax benefit should have given the taxpayer pause that something was wrong with the result spit out by Turbo Tax. If the COD was excluded, it would have reduced her adjusted basis in the property, so the claimed loss would not exist. This makes the taxpayer far less sympathetic than the court suggests. So Judge Holmes spends a lot of time on the straightforward substantive issue and then rushes through the much more interesting penalty issues.

Posted by: Gregg Polsky | Mar 19, 2018 7:07:19 AM

I am surprised, Bryan and Gregg, that you disagree that the penalty, absent section 6751, should apply. Yes, the wife went to law school. However, my property law course in law school did not cover recourse and nonrecourse debt. I don’t see why a California law school would be any different. There is one note in the Dukeminier casebook on anti-deficiency statutes, but most professors don’t get to it, and there is no mention of the vast tax implications. I took one tax course in law school, and the class did not cover recourse and nonrecourse debt there either (yes, we were coddled in my baby tax class). It was not until my tax LL.M property tax course that I learned about recourse and nonrecourse debt, and I did not make the connection to anti-deficiency statutes at the time. Then I forgot about nonrecourse debt for 10 years until I went into academia. I teach recourse and nonrecourse debt most years, but in other years I decide not to go through the trouble. Students in my classes struggle with the concept because it is so new to them and even more foreign than other concepts in baby tax. My guess is that it is a concept that is forgotten faster than any other topic in law school. It is understandable that Turbo Tax apparently does not incorporate the concept into its computations even though taxpayers pay a premium for the package where it should be. It is even less surprising that a taxpayer failed to recognize that Turbo Tax was giving a result that would look absurd to you guys. Yes, the computation is easy for you guys, but you guys have been developing your expertise in tax law for decades, and, despite being perhaps two of the greatest minds in tax law, you apparently don't remember your pre-tax days as mere mortals.

Posted by: Allen Madison | Mar 19, 2018 8:37:29 AM

Allen,

Even if the debt was recourse, the applicable COD exclusion requires the home to be her principal residence, which it wasn't. And even if it was, the exclusion requires a basis reduction, which would have negated the claimed loss. Simply put, no set of facts existed that would allow the taxpayer to both exclude the COD income and keep the basis. In my mind the facts that (1) the taxpayer was clearly wrong on the law and (2) the result was too good to be true warranted the penalty. The defense of "only a tax expert could figure out the right answer" isn't persuasive to me when a taxpayer claims a too-good-to-be-true result.

Posted by: Gregg Polsky | Mar 19, 2018 9:04:32 AM

@Allen: your good comment is exactly why I said "reasonable minds can disagree"! So I think lots of folks will agree with you. I cannot resist, however, making two follow-up points.

First, the taxpayers here could get to the right answer by reading the Regulations. Treas. Reg. 1.1001-2 and 1.165-9 give you pretty clear guidance.

Second, the taxpayers here could get to the right answer by reading the forms they received and the related publications. I have to give a shout-out to the otherwise un-recognized and anonymous IRS employees who work so hard in creating the various publications to help taxpayers like these. They really do a great job, overall, in making tax law complexities accessible. I note again that 1099-C instructions tell taxpayers they can consult Pub. 4681. When you do, recourse and non-recourse is all over that pub. AND the Pub tells you to go read Pub. 544. When you do, the language and example in IRS Pub 544 give you clear instructions.

So even assuming that the regulations are per se too complex for most taxpayers (but, really, the person who prepared this return was a JD), you at least have the forms instructions and publication guidance available.

If you take the position that a taxpayer who fails to follow any of this guidance and submits a significantly inaccurate return is excused from the accuracy-related penalty because the law is just “too complicated” for Turbo-Tax then you are effectively telling taxpayers they will incur no costs if they use Turbo-tax and then go read a bunch of irrelevant tax publications. Ignorance of the tax law may sometimes be an excuse from section 6662 penalties. But I think you have to do more than the taxpayers did here. Again, however, reasonable minds disagree, as evidenced both by your comment and by Judge Holmes' opinion.

I note that if these taxpayers had used a return preparer, given the return preparer all the relevant information, and the return preparer had committed the same error, I think the return preparer would get hit with penalties under 6694 for taking the position these taxpayers took.

Posted by: Bryan Camp | Mar 19, 2018 9:27:54 AM

Bryan and Gregg,
I appreciate your responses to my post responding to your posts. Reasonable minds can differ, especially when discussing reasonable cause. The defense exists literally so that people who make an honest effort to comply with the law aren’t penalized. Treasury Regulation §1.6664-4(b) (relied on by the court) provides:
“[T]he most important factor [to show reasonable cause under this subsection] is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability. Circumstances that may indicate reasonable cause . . . include an honest misunderstanding of fact or law . . . .”
As you have, Bryan, I have come to appreciate how much manpower and legal advice goes into creating form instructions and IRS publications. It seems like a taxpayer ought to be able to rely on them. And, in the Simonsen case, they did. Mrs. Simonsen did not rely solely on Turbo Tax. She “consulted the IRS’s own instructions to determine how to properly report [her tax obligation].” Doing so apparently did not dissuade her from the position she took because “the IRS Instructions to Form 982 and IRS Publications 4681 and 523 are consistent with the Simonsens’ view that one needs to make a downward basis adjustment only if one keeps the property after the debt is canceled.” Slip Op., at 28

Accordingly, this case does not give rise to a Turbo Tax defense because she looked to the IRS’s rules, which did not dissuade her from her position. This is a standard “making an honest effort to comply” case.

I have benefited from “too good to be true” results. Sometimes Congress is really trying to give taxpayers a benefit. I taught in Spain for a school year. I was shocked to find out that section 911 exempted from tax the income I earned there. That was too good to be true, but that’s what Congress wanted, and I claimed the exclusion. I don’t think the Simonsens’ position was “too good to be true” to a higher degree than the exclusion I claimed. But reasonable minds may differ.

Posted by: Allen Madison | Mar 19, 2018 1:19:32 PM

To qualify for section 108 treatment the house had to have been the taxpayers' primary residence for two of the previous five years, right? Wasn't that the case here? Or am I missing something?

Posted by: Nathan | Mar 19, 2018 5:30:30 PM

@Nathan: yes, you are missing the same thing that the taxpayers missed here: Section 108 is not relevant to the tax treatment of the Cancellation of Indebtedness when you short sale property on which the forgiven loan was non-recourse. Or at least I don't see how it is relevant (I still invite anyone who thinks it is to explain).

The taxpayers here were lured into thinking 108 applies because Wells Fargo sent them a 1099-C. But if they had read the Form 1099-C instructions with reasonable care, they would have found that the discharge of a non-recourse loan as part of a short sale of the encumbered property do not count as Cancellation of Debt but must instead be counted as part of the sales price, or “amount realized.” IMHO they did not read those instructions with reasonable care or otherwise take reasonable action to see whether section 108 applied. They just assumed.

Part of the problem is a common confusion that third party reporting forms always mean that what is reported as a payment must be reported as income. Not true. For example, when my grandmother passed away in 1996, she left her Houston home to me and my two sisters. That bequest was excluded from income, of course, under section 102(a). It was a gift. But I still got a Form 1099 from the title company when we sold the home because they had to report what they paid to me. Naturally, I did not report that amount as income, but two years later I got a “love letter” from the IRS saying that I had 30 days to explain why I had not reported that amount as income (it was about $32,000). So I did, sending in a copy of the will. But that’s what I mean. The obligation on folks like title companies and banks to report certain payments is just an obligation to report what THEY do. It does not mean those payments are income. Contrariwise, just because you DON’T receive a 1099 or W-2 does not mean what you got paid is excluded from income. My daughter earned about $450 last year working as a part-time employee during the Thanksgiving-Christmas holiday. No 1099. No W-2. But she still had to report that $450 as income.

Hope that helps!

Posted by: Bryan Camp | Mar 19, 2018 8:40:38 PM

Shame on the judge. The dicta is not much more than incorrect drivel. Back to baby judge school is in order.

Posted by: Steven M. Harris | Mar 25, 2018 7:53:01 AM