Real Estate Investor Couldn't Rely on CPA to Excuse Accuracy-Related Penalties

(Parker Tax Publishing October 2023)

The Tax Court held that a taxpayer who improperly claimed depreciation deductions for the value of commercial by applying a seven-year depreciation period rather than a 39-year period and claimed the same home mortgage interest deduction twice on a tax return did not qualify for the reasonable cause and good faith exception to accuracy-related penalties in Code Sec. 6664(c)(1). The taxpayer asserted that he relied in good faith on his CPA who prepared his return but the court found no evidence that the CPA told the taxpayer that the 7-year depreciation schedule applied to commercial buildings or that the mortgage deduction could be claimed twice. Johnson v. Comm'r, T.C. Memo. 2023-116.

Background

John Johnson has been engaged in the business of buying, selling, and leasing real estate for more than 50 years. In 2006 he purchased two hotel properties (i.e., the Lawton Hotel property) for $41,126,005. From 2006 to 2013, Johnson improperly claimed depreciation deductions amounting to 100 percent of the value of the commercial buildings. He accomplished this by applying a seven-year depreciation period to the commercial buildings, which should have been subject to a 39-year depreciation period. Johnson sold the Lawton Hotel property in 2016 for $5 million.

On the joint return Johnson and his wife filed for 2015, the Johnsons properly claimed a home mortgage interest deduction of $44,806 on Schedule A, Itemized Deductions. They also claimed the same $44,806 on Schedule E, Supplemental Income and Loss, as mortgage interest related to a commercial property in Valdez, Alaska. For 2015, the Johnsons claimed a charitable contributions deduction of $152,500. They attached an incomplete Form 8283, Noncash Charitable Contributions, specifying that $2,500 of this deduction was attributable to a donation of fencing to Ka Hale Pomaikai, a rehabilitation center in Hawaii, and $150,000 to the donation of a building to the Elgin Opera House in Oregon. They did not obtain a qualified appraisal for the donation of the building. The recipient of the building did not sign the Form 8283. They did not submit a contemporaneous written acknowledgment or receipt from either recipient as part of the 2015 return or at trial. The portions of Form 8283 that call for the signature of an appraiser and the signature of a representative of the Elgin Opera House were left blank. The submitted form describes the donated property as "Building" without any further identifying information and describes the condition of the property as "Good used."

Because of the Johnsons' improper depreciation deductions claimed between 2006 and 2013, the IRS made a Code Sec. 481 method of accounting adjustment for 2015 of $1,969,976. The IRS also proposed a number of adjustments as appropriate for the other mistakes on their returns for tax years 2015-18. The Johnsons conceded the correctness of these adjustments other than the accuracy-related penalties. In October 2020, the Johnsons filed a petition with the Tax Court, arguing that t they relied on their CPA and should qualify for the reasonable cause and good faith exception provided in Code Sec. 6664(c)(1).

Code Sec. 6662(a) imposes a 20 percent accuracy-related penalty on the portion of an underpayment of tax attributable to any of the reasons listed in Code Sec. 6662(b), including negligence or disregard of rules or regulations or a substantial understatement of income tax. Under Code Sec. 6662(c), negligence "includes any failure to make a reasonable attempt to comply with the provisions of this title." Disregard includes careless, reckless, or intentional disregard.

Code Sec. 6664(c)(1) provides that if the taxpayer shows that there is reasonable cause for any portion of an underpayment, and the taxpayer acted in good faith with respect to that portion, no accuracy-related penalty may be imposed on that portion of the underpayment. Under Reg. Sec. 1.6664-4(b)(1), the determination of reasonable cause must be made on a case by case basis, taking into account all pertinent facts and circumstances. The most important factor in this determination is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability. Reasonable reliance on the advice of an independent, competent professional as to the tax treatment of an item may meet the requirement of ordinary business care and prudence. The taxpayer's education and business experience are relevant to the determination of whether the taxpayer's reliance on professional advice was reasonable and in good faith.

In Neonatology Assocs., P.A. v. Comm'r, 115 T.C. 43 (2000), aff'd 299 F.3d 221 (3d Cir. 2002), the Tax Court held that in order for a taxpayer to reasonably rely on advice of a professional, the taxpayer must prove (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided all necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment.

Analysis

The Tax Court sustained the IRS's determination that the Johnsons were liable for the Code Sec. 6662(a) accuracy-related penalties as laid out in the notice of deficiency.

The court found that the Johnsons satisfied each of the first two prongs of the reasonable reliance test laid out in Neonatology. Their CPA was a competent professional and the Johnsons provided her with all necessary and accurate information. The third prong required that the taxpayers reasonably relied in good faith on the advice of a tax professional. The court said that. in order for such reliance to exist, the Johnsons would first have to establish that their CPA communicated something constituting advice.

The court found that there was no evidence that the Johnsons' CPA told them that the seven-year depreciation schedule was applicable to commercial buildings or that the mortgage interest deduction could be claimed twice. The Johnsons also failed to show, the court found, that their CPA advised them that the county assessor's valuation would suffice instead of a qualified appraisal for the building donated to the Elgin Opera House. The court noted that when asked whether she advised Mr. Johnson that the charitable contribution deduction could be claimed using the county assessor's valuation instead of a qualified appraisal, the Johnsons' CPA testified that she "never had that discussion with [Mr. Johnson.]" The court reasoned that the Johnsons could not claim to have reasonably relied on advice which was never given. The court concluded that the Johnsons failed to meet their burden of establishing that they received any advice about the propriety of claiming a charitable contribution deduction over $5,000 without a qualified appraisal or any advice concerning the proper tax treatment of any of the understatements.

The court rejected the Johnsons' contention that they were entitled to the reasonable cause and good faith exception merely because their CPA prepared the returns. The court noted that in Neonatology, the court held that "the mere fact that a certified public accountant has prepared a tax return does not mean that he or she has opined on any or all of the items reported therein." The court observed that taxpayers have a nondelegable duty to review the return for accuracy before filing. The court was unpersuaded that Mr. Johnson - a sophisticated participant in real estate transactions - would have missed the duplicate interest deductions, the grossly overstated depreciation, or the lack of a qualified appraisal if he had conducted even a cursory review of the returns.

For a discussion of abatement of penalties due to reasonable cause and good faith, see Parker Tax ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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