Paul L. Caron
Dean


Monday, August 26, 2019

Lesson From The Tax Court: The Proper Role Of Market Value In Casualty Loss Deductions

Tax Court (2017)I teach the §165 casualty loss deduction even though Congress has suspended it until 2026.  That is because Congress continues to permit casualty loss deductions for federally declared disasters, as defined in §165(i).  Since global climate change is causing more intense hurricanes, and may also increase the frequency of earthquakes, we can expect plenty of opportunities to apply the casualty loss deduction rules in the coming years.  You can find a list of federally declared disasters here.

When I teach §165, I emphasize to my students that mere loss of fair market value (fmv) is neither sufficient to trigger the deduction nor always the measure of the deduction.  The taxpayer must tie the loss of market value to the physical damage caused by the casualty.  Last week's case of Robert G. Taylor, II v. Commissioner, T.C. Memo 2019-102 (August 19, 2019)(Judge Paris) teaches that lesson.  There, a Houston taxpayer sold his home as a $12 million teardown after Hurricane Ike, but could not tie the loss of market value to the physical damage sustained and so lost that issue in Tax Court.  Details below the fold.

Law:  Relevant Casualty Loss Rules

Section 165(c) permits individual taxpayers a deduction for losses resulting from “fire, storm, shipwreck, or other casualty, or from theft.”  Section 165(h)(5) says that until 2026 the casualty must also qualify as a federally declared disaster (you can find the list here). 

As to entitlement, a casualty event is one that is sudden and unexpected.  Hurricanes fit the definition easily.  Termite infestations do not.  See Dodge v. Commissioner, 25 T.C. 1022 (1956).  The event must also cause physical damage.  The classic case is Pulvers v. Commissioner, 407 F.2d 838 (9th Cir. 1969).  There, a mudslide wiped away three nearby homes but did not physically damage the taxpayer’s home.  The taxpayers tried to take a casualty loss for the resulting decrease in fair market value.  The courts said “no.” 

As to amount, I think of §165 as a capital recovery provision.  It protects taxpayers from losing that which they have put into property, but no more.  The statute makes basis the upper limit of the deduction, saying that the amount of the loss is the taxpayers “adjusted basis provided in section 1011 for determining the loss from the sale or other disposition of property.”  Treas. Reg. 1.165-7(b)(1) says the deduction might be less than basis, however.  It says the permitted deduction is the lesser of basis or loss of fair market value.  While personal casualty amounts are limited by a 10% floor and an annoying $100 de minimis rule, neither of those limitations are relevant to this case so I’ll ignore them.

The important law to know for this case is the rule that taxpayers must link the amount of their casualty loss to actual physical damage.  You see his in several ways.  First, Reg. 1.165-7(a)(2)(i) says the taxpayer can prove loss of fair market value by a “competent appraisal” but then warns that such appraisal “must recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this section shall be limited to the actual loss resulting from damage to the property.”  Second, the safe harbor rule in Treas. Reg. 1.165-7(a)(2)(ii) is also linked to actual physical damage.  That provision permits taxpayers to use their cost of repairing actual physical damage as the measure of fmv loss. 

Case law also requires taxpayers to link any diminution in FMV to actual physical damages.  Judge Paris cites load of precedent for the proposition that “only those losses are deductible which are the result of actual physical damage to the property.”  In particular, temporary market decreases “due to buyer resistance” created by the casualty event are not deductible.  For example, when a taxpayer’s home suffered some minor physical damage in 1965 from a landslide, but then the taxpayer sold the house for a huge actual loss in 1966, it was too bad, so sad.  The Tax Court said “The loss petitioner suffered in 1966 was a loss on the disposition of his house, not a casualty loss. It was a loss suffered by petitioner because of his personal decision to dispose of the house while its market price was still affected by the buyer resistance occasioned by the landslide.”  Kamanski v. Commissioner, T.C. Memo 1970–352

The only glimmer of an exception to this is when the decrease in fair market value caused by the casualty event is “permanent.”  For example, in Finkbohner v. United States, 788 F.2d 723 (11th Cir. 1986), a flood wiped out the taxpayer’s neighborhood to the extent that 7 other homes were eventually razed, with the land acquired by the local government to be permanently undeveloped.  A split panel of the 11th Circuit held that the resulting loss of fmv was not merely a fluctuation but was permanent and was caused by the flooding.  The dissent pointed out that the other homes were razed based on the area's long known propensity to flood and the particular flood had not permanently altered the character of the land.  Finkbohner remains an outlier. 

Facts

Mr. Taylor is rich.  How rich is he?  So rich that in 1999 he spend over $9 million to buy “as is” a fancy home---designed by the famous architect John Staub---in a really swank neighborhood in Houston---River Oaks.  Mr. Taylor lived in the home until he decided to sell it in 2007.  He listed the property in 2007 for $18.5 million.  The listing contract ran through January 2009.  The opinion is silent on whether that huge appreciation in value was the result of general market conditions or something Mr. Taylor did to improve the property.   The opinion is silent on whether Mr. Taylor was unduly optimistic in his listing price.

Nature, it turns out, does not necessarily spare even the swankiest neighborhoods.  In September 2008 Hurricane Ike hit and Houston became a federally declared disaster area.   Mr. Taylor’s home sustained damage to the trees and grounds, and significant flooding in the basement where Mr. Taylor kept his 6,889-bottle wine collection.

Mr. Taylor took the house off the market pending repairs.  He filed insurance claims.  In them he asserted the “actual cash value of all property” was $15.5 million.  Mr. Taylor’s insurance company reimbursed him over $2.3 million for the repairs he made, including $1.5 million for the ruined wine. During the repairs, workers discovered asbestos in the home.  

Mr. Taylor’s 2008 tax return took the position that his basis in the home was $6.5 million, that the home had lost $3.2 million in market value because of Hurricane Ike, and that of that loss, he received compensation of $2.3 from insurance.  Thus, he sought a casualty loss deduction of about $900,000.  That represented the uncompensated portion of the asserted loss in fmv.   His return reported a pre-casualty fmv of just under $15.5 million and a post-casualty fmv of just under $12.3 million. 

Mr. Taylor eventually sold the property in 2014 for an even $12 million.  It was an unusual sale because he sold only the land, keeping all rights to use the home and other improvements for 30 months after the sale, including the right “to remove and salvage any or all of the improvements and fixtures.” And, in fact, Mr. Taylor continued to live in the home for most of those 30 months.  Writes Judge Paris, “as of May 2017...was still salvaging items from the property.” Then, in July 2017, either Mr. Taylor or the new owner tore the house down.  The news reports of the demolition are not clear on who did it.  Nor is it clear to me why Judge Paris' opinion stops "as of May 2017" when it was released in August 2019.  Just one of those mysteries.

The IRS audited Mr. Taylor’s 2008 return, found a deficiency, and Mr. Taylor petitioned the Tax Court in January 2013.  At that time he obtained a pre-hurricane and post-hurricane appraisal of the property from one Ms. Woodum.  Let’s call it the litigation appraisal.  The appraiser opined that the pre-hurricane value of the property was greater than Mr. Taylor had reported on his return and that the post-hurricane value was less.  In particular, the appraiser concluded that the land alone was worth $10 million both before and after the hurricane but that the home fair market value declined 95%, from almost $8 million before the hurricane to only about $400,000 after the hurricane.

Oh Happy news!  Was the litigation appraisal's conclusion just coincidence, or was it part of a litigation strategy?  After all, with a bigger fmv loss, a loss prepared by an expert, the IRS might be willing to settle the case and concede that at least some of Mr. Taylor’s $900,000 loss was proper.  The IRS might prefer that outcome rather than run the risk of the Tax Court accepting the litigation appraisal and deciding that Mr. Taylor was due a refund, as Mr. Taylor’s attorneys requested in a supplement to the Tax Court petition.

No such luck.  The IRS stuck to its argument: any loss of fmv greater than the cost of repairs was a temporary market fluctuation due to buyer resistance. 

Lesson: Casualty Loss Must Link to Physical Damage

Judge Paris sustained the deficiency.  Her opinion carefully explains the litigation appraisal’s shortcoming: it failed to link the change in fmv to the physical damage.  At trial, the appraiser, Ms. Woodum, testified that the property was “stigmatized” both by the flooding and by the discovery of asbestos (which is not a casualty event).  In addition, she acknowledged that, generally, the real estate market was hurt in 2008 because of the Great Recession. 

Ms. Woodum did not include any post-hurricane sales of comparable properties in her analysis.  Whoops.  That disqualified the appraisal right there, because without such comps it became impossible to meet the regulatory requirement that the appraisal “recognize the effects of any general market decline affecting undamaged as well as damaged property which may occur simultaneously with the casualty, in order that any deduction under this section shall be limited to the actual loss resulting from damage to the property.”

Thus she was unable explain to Judge Paris’ satisfaction how much of the claimed 95% decline in value of the home (apart from the underlying land) was due to the physical damage inflicted by Hurricane Ike and how much was attributable to (1) buyer resistance, (2) asbestos, and (3) the general market downturn.  Loss of value because of stigmatization could not count towards the casualty loss because that was just temporary buyer resistance.  Loss of value due to asbestos also could not count because the asbestos was not a separate casualty event.  Finally, loss of value due to the general market downturn could not count because it was not even linked to the casualty event, much less to the physical damage caused by the casualty event.  Without being able to separate out those other causes, the appraisal was simply not good enough to support the taxpayer’s claimed loss of fmv.

That left Mr. Taylor with the $2.3 million as best evidence of the change in fmv.  Judge Paris noted another shortcoming, however: $1.5 million of the $2.3 million in insurance payments were made to cover the loss of Mr. Taylor’s extensive wine collection.  The problem for Mr. Taylor here was that he was unable to establish his basis in the wine collection, in part because his customized computer system was also wiped out by the basement flooding.  Thus, as Judge Paris notes, Mr. Taylor could not even compute a loss for the wine.  That made his total insurance payments “well in excess of the cost of repairs he would otherwise be entitled to deduct as a casualty loss.”  In other words...he had a casualty gain!  Fortunately for Mr. Taylor, the IRS had not pressed that on audit.  Also fortunate was Judge Paris’ finding that Mr. Taylor had reasonably relied on his CPAs so that he would not be liable for a §6662 penalty.

Thus, just as the sale of property for $12 million that he bought for $9 million was not a total loss, neither was his Tax Court adventure.  He ended up avoiding the $81,000 penalty and avoided having to deal with a potential casualty gain.  Sounds like a good enough reason to open one of those bottles of wine in his restored collection, but perhaps just a modestly priced one.

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech School of Law.

https://taxprof.typepad.com/taxprof_blog/2019/08/lesson-from-the-tax-court-the-proper-role-of-market-value-in-casualty-loss-deductions.html

Bryan Camp, New Cases, Scholarship, Tax, Tax Scholarship | Permalink

Comments

Classic trouble with law articles dealing with topics they don't understand. The link to the NOAA GFDL article provided actually doesn't say what he claims it says.

"We find that, after adjusting for such an estimated number of missing storms, there remains just a small nominally positive upward trend in tropical storm occurrence from 1878-2006. Statistical tests indicate that this trend is not significantly distinguishable from zero."
There's a lot of theory and speculation on the future, but no support for the declaration that we are getting more intense hurricanes.

Law school faculty tend to seize on the most outrageous claims, becoming shills for media portrayals of science they don't comprehend.

Posted by: ruralcounsel | Aug 26, 2019 3:44:32 AM

@rural counsel.

I invite you to read the NOAA website more carefully.

Your cherry-picked quote is certainly part of the literature. It is indeed the finding of ONE of the existing studies that NOAA reviews and considers in reaching its conclusion.

I think you missed the overall conclusion, however, where NOAA says: "A review of existing studies, including the ones cited above, lead us to conclude that: it is likely that greenhouse warming will cause hurricanes in the coming century to be more intense globally and have higher rainfall rates than present-day hurricanes."

I put the link in so folks can decide for themselves, if they care to. I won't debate this any further.

As to your comment about me being a "shill" for the "media," get a grip. NOAA is not "the media." And a "shill" is someone who praises or promotes something because they secretly have a personal stake in it. I am hardly praising or promoting global warming. Nor, sadly, will NOAA be giving me a dime for linking to their site.

Geez Louise .

Posted by: bryan | Aug 26, 2019 5:48:36 AM

@ rural - I really, really, really, wish we had a "like" button on here.

Posted by: Dale Spradling | Aug 26, 2019 6:21:18 AM

@ Byran - why bring it up in the first place?

Posted by: Dale Spradling | Aug 26, 2019 12:15:18 PM

The reason for mentioning climate changes is that it is exacerbating the risk we face from a variety of natural disasters.

In 2017 there were 16 disasters with a billion dollars or more of damage. The total cost that year came to over $300 billion. (Damage in 2017 includes hurricane Harvey, which devastated Houston at a cost of $125 billion.) https://www.climate.gov/news-features/blogs/beyond-data/2017-us-billion-dollar-weather-and-climate-disasters-historic-year In contrast, the damages in the case above came from Hurricane Ike in 2008. Harvey was a bigger, wetter, slower moving storm, and that fits with models - hurricanes are gaining more energy and more moisture because they are developing over a warmer ocean.

For a discussion of the science, I would encourage you to consult the National Climate Assessment, a federally mandated report compiled by 13 federal agencies, more than 300 climate scientists, and fact checked in an extensive review process. (https://nca2014.globalchange.gov/report) Additional information can be found in the associated Climate Science Supplement. (https://nca2014.globalchange.gov/report/appendices/climate-science-supplement) For analysis of hurricanes in particularly, see Supplemental Message 9 on extreme events.

Posted by: Lorax | Aug 27, 2019 8:15:38 PM

@Lorax, I live in the Houston area. Hurricane Ike was a nothing burger. It went east of Houston. This taxpayer swung for the fences and, correctly so, struck out. It's too bad his wine cellar flooded, but that had nothing to do with climate change. Personally, I've have a butt full of fear mongering. Mentioning climate change in the context of discussing this Tax Court case is nothing more than pandering.

Posted by: Dale Spradling | Aug 28, 2019 6:26:37 AM