Sometimes in life, we say things because we think we’re supposed to say them, even if they may not always be 100% truthful. Things like:
“You have a beautiful home here!”
“What an adorable baby!”
“You’re a great girl. I’ll call you some time. Now can you help me find my pants?”
Such courtesies extend equally to the tax world. For example, many tax advisors, when explaining potential areas of exposure to clients on things like purchase price allocations, recite the old adage “the IRS doesn’t like to play the role of valuation expert.”
But as the Tax Court proved yesterday in Shepherd v. Commissioner, that’s not always the case. To the contrary, when the situation calls for it, the IRS is more than happy to play the role of valuation expert, or at least dabble in the valuation world just long enough to deny a deduction or exclusion from income.
To wit: Bernard Shepherd owed $9,000 on a credit card. In 2008, he settled his debt for $5,000, and the credit card company issued a 1099-C indicating that Shepherd recognized $4,000 of cancellation of indebtedness (COD) income upon settlement of the debt.
On his 2008 tax return, Shepherd excluded the COD income under the belief that he qualified for the “insolvency exclusion” of I.R.C. § 108(a)(1)(B). As a reminder, the insolvency exclusion permits a taxpayer to exclude COD to the extent the taxpayer was insolvent immediately prior to the debt discharge.
Section 108 further provides that the term “insolvent” means “the excess of liabilities over the fair market value of assets” immediately prior to the debt discharge. In Shepherd, it was stipulated that Shepherd had non-real estate assets valued at $30,000 and liabilities of $800,000. The center of the dispute, however, was the fair market value of Shepherd’s principal residence and beach home.
In computing his insolvency, Shepherd included his primary residence at a value of $380,000. His only support for this value was 1) a letter from his mortgage lender stating that the value of the home in 2011 was $380,000, and 2) a property tax bill.
The problem with the lender’s letter, of course, was that the value of the home must be determined immediately prior to the discharge, which occurred in 2008. Here, the lender provided the value of the home in 2011, rendering it irrelevant to the insolvency computation.
With regards to the property tax bill, the Tax Court concluded that “a value placed upon property for the purpose of local taxation, unsupported by other evidence, cannot be accepted as determinative of fair market value for Federal income tax purposes in the absence of evidence of the method used in arriving at that valuation.” In addition, because the home was located in New Jersey, where it is well established that the assessed value of property for property tax purposes is generally not equivalent to the FMV of the property, the Tax Court lent no credence to the $380,000 assessed value.
After applying the same logic to Shepherd’s beach house– whose value was supported only by a property tax bill — the court concluded that because of Shepherd inability to establish the FMV of his homes, he failed to establish that he was insolvent under the meaning of I.R.C. § 108. The Tax Court didn’t need to determine the value of the homes, only that Shepherd hadn’t met his burden of proof in establishing his insolvency.
In an interesting ancillary aspect of the decision, the Tax Court also concluded that in computing his insolvency, Shepherd was required to include in his assets his pension fund to the extent he could borrow against the fund, even though the pension fund was exempt from the claims of creditors.