Bankruptcy & Insolvency
The Tax Court held that a married couple had failed to prove the fair market value (FMV) of their two homes and the husband’s pension and thus were not entitled to exclude discharge of indebtedness income from their gross income under the Sec. 108(a)(1)(B) insolvency exclusion because they could not prove they were insolvent.
In November 2007, Capital One Bank (Capital One) referred Bernard and Desiree Shepherd’s delinquent credit card account to an outside collection agency. The principal loan balance due on the couple’s Capital One account at the time of the referral was $9,962.06. The Shepherds entered into a settlement agreement with the outside collection agency, agreeing to settle the Capital One loan balance for $5,550. The petitioners made payments totaling $5,550 from March 28 to July 30, 2008. Capital One coded the account as “Settled in Full” and discharged the remaining liability on Sept. 3, 2008.
In January 2009, Capital One issued Mr. Shepherd a Form 1099-C, Cancellation of Debt, showing that $4,412 of indebtedness had been canceled on Sept. 3, 2008. The Shepherds did not report the $4,412 as income on their 2008 joint federal income tax return because they believed that the income was excludable under the insolvency exception of Sec. 108(a)(1)(B), which allows an insolvent taxpayer to exclude discharge of indebtedness income from gross income to the extent the taxpayer is insolvent.
The IRS determined that the Shepherds’ liabilities were not greater than the FMV of their assets immediately before the discharge, and thus the couple were not insolvent for purposes of the exception. Therefore, the Shepherds were not entitled to exclude the income under the exception, and the IRS assessed a deficiency against them. The IRS contended that in calculating insolvency, the Shepherds had not properly valued their principal residence, a beach house they owned, and Mr. Shepherd’s pension in the New Jersey Public Employees Retirement System. The Shepherds challenged the IRS’s deficiency determination in Tax Court.
The Tax Court’s Decision
The Tax Court held that the Shepherds could not exclude the discharge of indebtedness income from their gross income. According to the Tax Court, to prevail, the Shepherds had the burden of proving that they were actually insolvent. The court found that the Shepherds had not proven their claimed values for the disputed assets. Because they could not prove the total value of their assets, they had not established that their liabilities exceeded their assets, and thus they had not proven they were insolvent and qualified for the insolvency exception.
In support of their claimed value for the beach house, the Shepherds offered as evidence a “Civil Action Stipulation of Settlement” (settlement) between the Shepherds and the city of Brigantine, N.J., which provided that the beach house’s value for local property tax purposes was $380,000 for the 2010 tax year. Petitioners signed the settlement on May 16, 2011. The court rejected this evidence because it had previously held that a value placed on property for the purpose of local taxation, unsupported by other evidence, cannot be accepted as determinative of FMV for federal income tax purposes in the absence of evidence of the method used in arriving at that valuation. The court also rejected Mr. Shepherd’s testimony about the value of the house, which he claimed he had based on his own review of comparable sales, because he offered no documentation of the comparable sales or the methodology he used to determine the value based on the comparable sales.
For their principal residence, the Shepherds offered as proof of its value a letter dated March 29, 2011, from Chase Home Finance LLC (Chase) showing the value of the principal residence; and a “2008 Final/2009 Preliminary Tax Bill” (tax bill). The court rejected the Chase statement as proof because it was dated three years after the discharge occurred, so it could not be proof of the house’s value immediately before the discharge, as required by Sec. 108(d)(3). It rejected the tax bill because, as it had explained with respect to the beach house, Tax Court precedent holds that an assessed value for local property tax purposes is not normally indicative of the property’s FMV. In addition, the court noted that New Jersey law for property assessments specifically contemplates that the assessed value of a property for tax purposes is not equivalent to the property’s FMV.
The Shepherds argued that no part of Mr. Shepherd’s pension account should be included in the insolvency calculation, despite the fact they included loans from the pension account as a liability in the calculation. The Tax Court, once again citing its own precedent, found that assets, even those exempt from creditors, must be included in the insolvency calculation and, in the Shepherds’ case, the amount that Mr. Shepherd could take as loans from the account was the amount that they must use in calculating insolvency. However, because the Shepherds failed to show how much had been contributed to the account, the Tax Court found it could not determine the amount that they could have taken as loans.
While it is not clear from the opinion whether the Shepherds would have been considered insolvent if the real FMV of the houses had been determined, the Tax Court clearly was open to accepting an FMV based on comparable sales of properties at the time of the debt discharge. Given the relatively easy access to historical home sale information through the internet, determining a reasonable estimate of the historical FMV of a house would seem to be possible. As this case indicates, merely attempting to prove the FMV of real estate by showing the value of the real estate as assessed by a local authority for property tax purposes without any other evidence will almost certainly fail.
Shepherd, T.C. Memo. 2012-212