T.C. Summary Opinion 2016-28
UNITED STATES TAX COURT
BARTON SLAVIN AND AMY WEINSTOCK SLAVIN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7785-12S. Filed June 21, 2016.
Barton Slavin and Amy Weinstock Slavin, pro sese.
Theresa G. McQueeney, for respondent.
SUMMARY OPINION
GALE, Judge: This case was heard pursuant to the provisions of section
7463 of the Internal Revenue Code in effect when the petition was filed. Pursuant
to section 7463(b), the decision to be entered is not reviewable by any other court,
and this opinion shall not be treated as precedent for any other case.
-2-
Respondent determined the following deficiencies and accuracy-related
penalties under section 6662(a)1 with respect to petitioners’ Federal income tax for
taxable years 2007, 2008, and 2009 (years at issue):
Penalty
Year Deficiency sec. 6662(a)
2007 $3,066 $613
2008 11,792 2,358
2009 26,605 5,321
After the parties’ concessions,2 the issues for our consideration are
(1) whether petitioners are entitled to mortgage interest expense deductions for
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
2
For 2007 petitioners have conceded that they had unreported taxable
interest income, that they are not entitled to their claimed real estate loss deduction
in the amount that respondent has disallowed, and that respondent’s adjustments to
their claimed child tax credits are computational. For 2008 and 2009 petitioners
have conceded that they are not entitled to their claimed real estate loss deductions
in the amounts that respondent has disallowed and that the other adjustments,
including the taxation of State and local tax refunds, are computational. The
parties have also agreed that for 2009 petitioners had a $47,949 capital gain
taxable at the long-term capital gains rate. Respondent has conceded that
petitioners had reasonable cause for their failure to report the capital gain and that
they are not liable for the portion of the sec. 6662(a) penalty for 2009 attributable
to the capital gain adjustment.
-3-
taxable years 2008 and 2009 and (2) whether petitioners are liable for accuracy-
related penalties under section 6662(a) for the years at issue.
Background
Some of the facts have been stipulated and are so found. The stipulated
facts are incorporated herein by this reference. Petitioners resided in New York
when the petition was filed. Petitioner husband is a litigation attorney who also
has experience with real estate transactions. Petitioner wife worked in sales,
helped with petitioners’ rental activity, and cared for their children during the
years at issue.
During 2004 petitioners purchased from family friends (sellers) two semi-
detached houses in Rockville Centre, New York (collectively, property), as a
rental property. In lieu of obtaining third-party financing, on November 2, 2004,
petitioners executed a mortgage on the property and a promissory note for
$975,000 payable to the sellers. Under the terms of the promissory note,
petitioners were to make two interest-only payments per year representing an
annual interest rate of 6%3 until the maturity date in 2034, at which date the note
would be due in full. The interest payments were due in May and December each
3
As long as petitioners did not make principal payments, the semiannual
interest payments were to be $29,250.
-4-
year. The May interest payments were to be applied to the unpaid interest for
November and December of the previous year and to the unpaid interest for
January through April of the current year. The December interest payments were
to be applied to the unpaid interest for May through October of the current year.
Petitioners paid the sellers $54,000 of interest in 2007. However, the rental
property was not as profitable as petitioners had hoped, and they did not make any
payments on the promissory note for 2008 or 2009. On June 10, 2008, petitioners
and one of the sellers executed a mortgage modification agreement capitalizing
$54,000 of unpaid interest for 2008 into the unpaid mortgage principal.4 On
October 15, 2009, petitioners and one of the sellers executed a second mortgage
modification agreement capitalizing $54,000 of unpaid interest for 2009 into the
unpaid mortgage principal.5 Neither of the mortgage modification agreements
altered the 6% annual interest rate.
After a series of conversations, the dates of which are not clear from the
record, petitioners and one of the sellers entered into an interest rate modification
4
The June 10, 2008, mortgage modification agreement stated that the unpaid
principal balance of the original promissory note was $980,000.
5
Although petitioners did not make any interest payments for 2008-09 and
although under the terms of the promissory note petitioners were to pay annually
$58,500 of interest spread over two payments, the mortgage modification
agreements addressed only $54,000 of unpaid interest for each year.
-5-
agreement on January 8, 2010. Under the terms of this agreement, the annual
interest rate as set forth in the promissory note was reduced from 6% to 3%
effective January 1, 2008. The interest rate modification agreement did not
address how the agreement to retroactively reduce the interest rate affected the two
mortgage modification agreements or the mortgage principal.
During the years at issue petitioners were cash basis taxpayers. They timely
filed joint Forms 1040, U.S. Individual Income Tax Return, for the years at issue.
Petitioners attached to each Form 1040 a Schedule E, Supplemental Income and
Loss, on which they reported that they were real estate professionals and claimed a
rental real estate loss deduction. On each Schedule E petitioners claimed, inter
alia, a mortgage interest expense deduction of $54,000. They did not submit into
evidence documentation sufficient to substantiate their status as real estate
professionals or their entitlement to the rental real estate loss deductions.
Petitioners hired Mayeer Karkowsky, a certified public accountant who is
also an attorney admitted to the U.S. Tax Court Bar, to prepare their Forms 1040
for the years at issue. Mr. Karkowsky appeared and testified at trial. He discussed
with petitioner husband before the filing of the Forms 1040 the mortgage interest
expense deductions for the years at issue, but he did not have either mortgage
modification agreement or the interest rate modification agreement when he was
-6-
preparing the returns. He advised petitioner husband that, because of the
capitalized interest and the interest rate reduction, petitioners’ mortgage had been
“substantially modified” under section 1.1001-3, Income Tax Regs., and therefore
petitioners qualified for the mortgage interest expense deductions.
Respondent issued to petitioners a notice of deficiency dated January 3,
2012, for the years at issue. Petitioners timely filed a petition for redetermination
of the deficiencies.
Discussion
I. Burden of Proof
Generally, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and the taxpayer bears the burden of proving that those
determinations are erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111,
115 (1933). The taxpayer likewise bears the burden of proving his entitlement to
deductions allowed by the Code and of substantiating the amounts of expenses
underlying claimed deductions. Sec. 6001; INDOPCO, Inc. v. Commissioner, 503
U.S. 79, 84 (1992); sec. 1.6001-1(a), Income Tax Regs. Under section 7491(a), in
certain circumstances, the burden of proof may shift from the taxpayer to the
Commissioner. Petitioners have not claimed or shown that they meet the
-7-
requirements of section 7491(a) to shift the burden of proof to respondent as to
any relevant factual issue.
II. Mortgage Interest Expense Deductions
Petitioners did not make any payments toward the promissory note for 2008
or 2009. Rather, the two mortgage modification agreements each capitalized
$54,000 of unpaid interest into the mortgage principal. Petitioners claimed on
their 2008 and 2009 Schedules E mortgage interest expense deductions for the
amounts of the capitalized interest. Respondent disallowed the claimed
deductions.
Section 163(a) provides that there shall be allowed as a deduction all
interest paid or accrued within the taxable year on indebtedness. Cash basis
taxpayers, such as petitioners, are allowed a deduction for interest paid during the
taxable year in cash or its equivalent. See Don E. Williams Co. v. Commissioner,
429 U.S. 569, 577-578 (1977); Davison v. Commissioner, 107 T.C. 35, 41 (1996),
aff’d, 141 F.3d 403 (2d Cir. 1998); Menz v. Commissioner, 80 T.C. 1174, 1185
(1983). When a lender capitalizes unpaid interest by adding the unpaid interest
amount to the loan principal, a cash basis borrower is not entitled to a current
interest deduction for the interest that is added to the loan’s principal balance.
Heyman v. Commissioner, 70 T.C. 482, 485-487 (1978), aff’d, 652 F.2d 598 (6th
-8-
Cir. 1980). Petitioners did not pay mortgage interest for 2008 or 2009 in cash or
its equivalent. The mortgage modification agreements did not constitute interest
payments but rather allowed petitioners to postpone the paying of interest. As
cash basis taxpayers, they are not entitled to deductions for the interest that was
capitalized into the unpaid mortgage principal.
Petitioners attempt to distinguish the above-cited caselaw by contending
that the capitalization of the 2008-09 interest was a true discharge of the interest
because there was a “substantial modification” of the promissory note under
section 1.1001-3, Income Tax Regs. Even if we were to accept petitioners’ theory
that there was a “substantial modification” of the promissory note for 2008-09,
which we do not, that theory does not help them. Section 1.1001-3, Income Tax
Regs., addresses when a modification of the terms of a debt instrument results in
recognition of gain or loss under section 1001. It does not concern the
deductibility of interest payments.
Moreover, Allan v. Commissioner, 856 F.2d 1169 (8th Cir. 1988), aff’g 86
T.C. 655 (1986), which petitioners cite in support of their case, is distinguishable.
That case concerned accrual basis taxpayers, which petitioners are not, and
addressed whether capitalized interest was properly includible in the taxpayers’
amount realized upon foreclosure of the mortgaged property. See Smoker v.
-9-
Commissioner, T.C. Memo. 2013-56, at *12-*13 (explaining that Allan does not
support a cash basis taxpayer’s claimed deduction for unpaid interest that was
capitalized into the principal of the loan).
As cash basis taxpayers, petitioners were not entitled to deduct unpaid
interest that was capitalized in the mortgage principal. We sustain respondent’s
disallowance of petitioners’ mortgage interest expense deductions for 2008-09.
III. Section 6662(a) Accuracy-Related Penalties
Respondent determined that petitioners are liable for accuracy-related
penalties pursuant to section 6662(a)for the years at issue. The Commissioner
bears the burden of production regarding a taxpayer’s liability for any penalty.
Sec. 7491(c); see Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). Once
the Commissioner has met this burden, the taxpayer must provide persuasive
evidence that the Commissioner’s determination was incorrect. See Rule 142(a);
Higbee v. Commissioner, 116 T.C. at 447.
Section 6662(a) and (b)(1) imposes a 20% penalty on any portion of an
underpayment of tax required to be shown on a return attributable to negligence or
disregard of rules or regulations. The term “negligence” includes any failure to
make a reasonable attempt to comply with the provisions of the internal revenue
laws, including any failure to maintain adequate books and records or to
- 10 -
substantiate items properly, and the term “disregard” includes any careless,
reckless, or intentional disregard. Sec. 6662(c); sec. 1.6662-3(b)(1) and (2),
Income Tax Regs. Negligence is strongly indicated where a taxpayer fails to make
a reasonable attempt to ascertain the correctness of a deduction, credit, or
exclusion on a return that would seem to a reasonable and prudent person to be
“too good to be true” under the circumstances. Sec. 1.6662-3(b)(1)(ii), Income
Tax Regs.
Petitioners conceded, inter alia, that respondent’s adjustments with respect
to their unreported interest income for 2007, their rental real estate loss
deductions, and their State and local tax refunds were correct. They also failed to
maintain adequate records showing their entitlement to the claimed rental real
estate loss deductions for the years at issue. Moreover, petitioners, especially
given petitioner husband’s background and education level, should have known
that, as cash basis taxpayers, they were not entitled to deduct unpaid interest.
Respondent has met his burden of production with regard to the imposition of
accuracy-related penalties for the years at issue.
Taxpayers may avoid liability for the section 6662 penalty if they
demonstrate that they had reasonable cause for the underpayment and that they
acted in good faith with respect to the underpayment. Sec. 6664(c)(1).
- 11 -
Reasonable cause and good faith are determined on a case-by-case basis, taking
into account all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income
Tax Regs. Generally, the most important factor is the extent of the taxpayer’s
efforts to assess his proper tax liability. Id. Circumstances that may indicate
reasonable cause and good faith include an honest misunderstanding of fact or law
that is reasonable in light of all of the facts and circumstances, including the
experience, knowledge, and education of the taxpayer. Id.
Reliance on professional advice may constitute reasonable cause and good
faith, but “it must be established that the reliance was reasonable.” Freytag v.
Commissioner, 89 T.C. 849, 888 (1987), aff’d on another issue, 904 F.2d 1011
(5th Cir. 1990), aff’d, 501 U.S. 868 (1991). The taxpayer’s education,
sophistication, and business experience will be relevant in determining whether
the taxpayer’s reliance on tax advice was reasonable and in good faith. Sec.
1.6664-4(c)(1), Income Tax Regs.
Petitioners argue that they acted in good faith by relying on professional
advice. Although petitioners demonstrated that their adviser was a competent
professional with sufficient experience to justify reliance, see Neonatology
Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d
Cir. 2002), we are not convinced they had reasonable cause and acted in good
- 12 -
faith. First, nothing in the record indicates that petitioners sought or relied on
advice from Mr. Karkowsky with respect to the adjustments that they have
conceded. See id. Second, with respect to the mortgage interest expense
deductions, petitioners have not proven that their reliance on Mr. Karkowsky was
reasonable. Although petitioner husband had discussed the mortgage interest
expense deductions with him, Mr. Karkowsky did not have the two mortgage
modification agreements or the interest rate modification agreement when he
prepared the returns. See id. (stating that taxpayers must provide necessary and
accurate information to their adviser).
Moreover, petitioners’ reliance on Mr. Karkowsky’s theory of the
deductibility of the interest was not reasonable. Even if petitioners did not
understand that section 1.1001-3, Income Tax Regs., was not applicable to their
situation, petitioner husband understood that Mr. Karkowsky’s advice was at least
partially based on the interest rate reduction from 6% to 3%.6 However, on each
of their 2008-09 Forms 1040, petitioners deducted mortgage interest expenses of
6
Although the interest rate modification agreement was not executed until
January 2010, we give petitioners the benefit of the doubt and assume, without
deciding, that they and the sellers had orally agreed to the interest rate reduction
before Mr. Karkowsky prepared petitioners’ 2008 Federal income tax return. If
there was no oral agreement before Mr. Karkowsky prepared petitioners’ 2008
Federal income tax return, petitioners’ reliance on Mr. Karkowsky’s advice for
their 2008 mortgage interest deduction would also be unreasonable.
- 13 -
$54,000. This is the same amount of interest that petitioners had deducted for
2007, when the interest rate was 6%. Especially given petitioner husband’s
education level, petitioners should have realized that an interest rate reduction
would have translated into a smaller mortgage interest expense deduction for the
year. Petitioners have failed to prove that they had reasonable cause or that they
acted in good faith, and they are liable for the section 6662(a) penalties for 2007
and 2008 and for the penalty for 2009 in excess of the amount that respondent has
conceded.
IV. Conclusion
We have considered the parties’ remaining arguments, and to the extent not
discussed above, conclude those arguments are irrelevant, moot, or without merit.
To reflect the parties’ concessions and the foregoing,
Decision will be entered
under Rule 155.