Yesterday, with the spurs a-jinglin’ and a-janglin’, the Tax Court rode into town and issued several opinions of note:

In Foy & Barbara Smith v. Commissioner, the Court looked at rental real estate activities, among other things. While Smith isn’t particularly instructive – it’s a pretty straightforward case – a few items stand out:

1. The taxpayers allocated the cost of land based upon their tax preparer’s method, which he in turn based upon his experience, and the standards he used for other clients;
2. The taxpayers claimed various expenses – replacing HVAC units, roof work and painting and carpets – instead of depreciating them, then challenged the IRS’ selected lifespans.

The first one is the most alarming, because it is a typical scenario where rental real estate is involved. You go into your tax preparer’s office, and he or she asks, “how much did you pay for it?” You tell him the price you paid, say, $250,000. You might (actually should, but many people aren’t so well-prepared) show him the HUD-1 closing statement. He then takes some portion, and calls it ‘Land,’ which he does not depreciate, and another portion and calls it ‘Building,’ which he does. This, he says, is what the code says to do (true), and he used his “knowledge of the area” in coming up with the allocation. And here’s where you could have a problem.

Some counties – Los Angeles County included – will put values on both the building and the land. If they do, watch out. In Smith, the IRS took those assessed values, and used them to establish new depreciation numbers. In the case of the Smiths, the impact was minimal (they only were looking at assessments of $966 and $3,909 for the years at issue), but for others it could be significant. Once the IRS introduced the assessor’s bill, the burden was on the Smiths to prove the bill wrong. The lesson is clear – don’t take the assessor’s valuations lightly if you own rental property. If they differ from your Schedule E valuation, you need to challenge them or be prepared to prove why your valuation is more right than theirs.

The second problem – claiming HVAC and other capital items as expenses – is a common dodge taxpayers use to avoid having to depreciate a low-cost (relative to the property value) item over a long period of time. The HVAC units (which were central air & heat) and the repairs to the roof were definitely capital improvements; no way they were going to get around the longer term depreciation. The carpeting and the painting, however, were arguably expenses. Problem was, they didn’t separate those costs from the roof repairs, and thus lost the capability of expensing them. The lesson here? Be sure to clearly identify each expense, or be able to prove them individually, lest you get burned in the same way.

The final issue in Smith was an abusive trust. Again, the taxpayers did not keep good records, and could not show exactly when they knew the investment was a total loss. The court seemed inclined to give them the loss, but chose not to do so when they couldn’t provide evidence of worthlessness, nor could they explain why an original investment of $37,000 only resulted in a $34,000 loss. Too bad.

In Linda K. Betts v. Commissioner, the Court offered yet another lesson to horse owners (and there are a lot of them in Los Angeles County) who seek to claim losses from their horses: it won’t be easy.

Betts involved a woman who worked making packaging designs for the pharmaceutical industry by day and in her free time raised horses. Well, a horse, at least. Prior to the packaging job, she’d owned a ranch on which she ran an ultimately unsuccessful horse business. The IRS had audited her then, and made no changes.

Skip forward a few years. Now she has a regular job, and decides to once again raise horses. She buys one horse, negotiating the price down from $15,000 to $1,000 from an owner who 1) did not keep the horse well and 2) just wanted to be rid of him. That second part should have been the first red flag.

Betts’ intent, which she stated at trial, was to sell this horse after training him. She had been told he could fetch upwards of $100,000, but that never occurred. Shortly after buying him, problems developed, and she eventually tried to sell the horse for $20,000, then $12,000, both a far cry from the $100,000 she claimed he was worth. Still, she stuck to the original $100,000 valuation at trial to validate the alleged profitability. In addition to this horse, she purchased another, which she sold for a $6,000 profit. Unfortunately, for the seven years under audit, she accumulated total losses of over $150,000.00.

The court disallowed all of the losses, and sustained the argument that, despite her investment of time and money, her horses were nothing more than a hobby.

Why? Let’s count the reasons:

1. She did not have a business plan, and when she finally did come up with one, it was lame. In fact, it consisted only of a statement on the number of horse owners nationwide, and in LA County, and not much more.
2. She admitted that horses were a risky proposition, and that she could lose money. And in fact she had lost money in her earlier attempt.
3. She did not clearly track her costs by animal to know if she was profitable. On the one horse she did apparently sell at a profit, she admitted that she did not separate her costs by horse, so could not say for certain if she did profit on the sale.
4. She did not take steps to reduce her losses or increase her income. In fact, she reduced some expenses – marketing, for one – which the Court thought evidenced a lack of effort to increase income.
5. She did not have adequate business advisers. While she did seek out several prominent people in the field, the court found she did not seek their counsel on business matters, or how to run her business better.

In fact, the court ran through the 9 (non-exclusive) profit objective factors in Section 1.183-2(b) and found her wanting in almost all of them. For the uninformed here are those factors:

1. The manner in which the taxpayer carries on the activity;
2. The expertise of the taxpayer or his advisers;
3. The time and effort expended by the taxpayer in carrying on the activity;
4. The expectation that assets used in the activity may appreciate in value;
5. The success of the taxpayer in carrying on other similar or dissimilar activities;
6. The taxpayer’s history of income or losses with respect to the activity;
7. The amount of occasional profits, if any, which are earned from the activity;
8. The financial status of the taxpayer; and
9. Elements of personal pleasure or recreation.

According to the court, “[n]o one factor is necessarily determinative in the evaluation of profit objective, nor is the number of these factors for or against the taxpayer necessarily determinative.”

Maybe not, but it should be clear to the horse owners of LA County (and elsewhere) that if you have a horse-based activity which generates tax losses, expect to be audited, and expect the IRS to look very closely at your activity.

In Wayne & Caroline Drown v. Commissioner, the taxpayers invested in Hoyt Farms, a discredited abusive tax shelter. The taxpayers – who chose, like Smith above, to represent themselves – got hit for additional taxes several years after filing. That was then. This is now – the IRS is now comin’-a-callin’ looking for penalties, specifically Section 6662 penalties. Them be the penalties fer negligence, pardner. And when you represent yourself, and prepare your returns yourself AND ignore IRS notices and claim you thought all was OK because you got what seemed to be a ‘never mind’ letter from the IRS, well … you got nuttin’ to hide behind. The best defense to a Section 6662 is to do what everyone else does – point the finger at the other guy (i.e., the taxpreparer). But…the Drowns (nice name, eh?) didn’t have that. So…the IRS got its couple.

Oh, don’t think they didn’t try to wriggle away. They cited Section 6502, the 10-year Statute of Limitations. No dice, said the court; the penalties haven’t been assessed yet, so the clock hasn’t even started, much less finished. They tried Section 6229, but the court noted that that statute had been suspended while the Final Partnership Administrative Adjustment (FPAA) proceeding was ongoing. So…that clock was still ticking, too. They were down to estoppel, which failed too, because the court found no misleading information had been provided by the IRS to justify estoppel.

The lesson here? Don’t think that tax shelter is getting you something for nothing – seek competent advice. A CPA would have likely advised them not to invest. Even if they’d ignored it, a good tax lawyer would have told them to pay the taxes, penalties and interest and cut their losses. If they wanted to fight it, do it in District Court, not Tax Court, where the meter still runs. Alas, they didn’t get that advice, and paid.