Co-op Owner Still Cannot Take Deduction for Wall’s Collapse

The Tax Court found that progressive deterioration caused the collapse of an 80-year-old retaining wall at a cooperative apartment complex, and thus the wall’s collapse was not a casualty for purposes of the Sec. 165(c)(3) casualty loss deduction.

Background

During 2005, the year at issue, Christina Alphonso owned shares of stock in Castle Village Owners Corp. (Castle Village), a Sec. 216(b) cooperative housing corporation. Castle Village owned a cooperative apartment complex that consisted of a seven-acre tract of land overlooking the Hudson River in New York City, on which a two-story cottage and five apartment buildings stood. The Castle Village apartment buildings ranged in height from 12 to 15 stories and contained a total of 589 apartments. Before May 12, 2005, an enormous retaining wall of stone masonry construction that had been built between 1921 and 1925 supported the grounds near those five Castle Village apartment buildings.

Concerned about the condition of the retaining wall, Castle Village began what would be a long series of inspections and studies of, and repairs to, the retaining wall, the part of the grounds adjacent to the walls, and the drainage system on that part of the grounds. Between 1985 and 2005, six persons or entities performed inspections or studies. The last company’s study, which included sophisticated measurements of the movement of the wall over an extended period, indicated that portions of the retaining wall had serious problems that could result in a failure of the wall. Over the 20-year period, Castle Village had a number of repairs made to the wall, the grounds, and the drainage system in response to the various inspections and studies. The last major work done was a 2004 renovation of the drainage system around the wall to prevent water from pooling near the wall when it rained.

On May 12, 2005, part of the Castle Village retaining wall collapsed, depositing large amounts of rock and soil onto the public roads below the Castle Village complex and causing significant damage. Castle Village levied an assessment against each of its stockholders, including Alphonso, to pay for the damage caused by the collapse of the retaining wall. The amount levied against Alphonso was $26,390, which she paid. On her timely filed individual tax return for 2005, Alphonso claimed a casualty loss of $26,390 and a casualty loss deduction of $23,188. The IRS issued her a notice of deficiency for 2005 in which it disallowed the claimed 2005 casualty loss deduction.

Alphonso challenged the deficiency determination in Tax Court. In its initial decision, the Tax Court held for the IRS, finding that Alphonso had no ownership interest in the retaining wall, which belonged to Castle Village, and therefore she could not take a casualty loss deduction related to the wall’s collapse. On appeal, the Second Circuit reversed the Tax Court, finding that under New York law, as a cooperative shareholder in Castle Village, Alphonso did have a property interest in the retaining wall, and it remanded the case to the Tax Court to consider the IRS’s alternative argument for denying Alphonso’s deduction, that the collapse of the retaining wall was not a casualty for purposes of Sec. 165(c)(3).

Back in Tax Court, the IRS argued that the cause of the collapse of the retaining wall was the progressive deterioration of the wall over time and thus the loss from the collapse did not qualify as a casualty loss under Sec. 165(c)(3). Alphonso argued that the cause was not progressive deterioration of the wall. Instead, she claimed that the collapse was due to excessive rainfall in the five months before May 2005, which overstressed the recently installed (but faulty) new drainage system and caused a rapid movement in the wall in the four weeks before the collapse. Consequently, the collapse was due to a sudden, unexpected, or unusual cause and was a casualty loss.

The Tax Court’s Decision

The Tax Court once again ruled in the IRS’s favor, holding that the collapse of the retaining wall was not a casualty within the meaning of Sec. 165(c)(3). Based on the reports from the inspections and studies over the 20 years prior to the collapse and the testimony of the IRS’s expert witness, the court found that progressive deterioration of the wall caused the collapse and that the rainfall in the months preceding the collapse was not a significant contributing factor.

Alphonso based her argument primarily on the Tax Court’s holding in Helstoski, T.C. Memo. 1990-382. In Helstoski, violent thunderstorms undermined the footings of a dam on the taxpayer’s property, causing the pond behind the dam to drain, which washed away an access road that led to the pond. This significantly decreased the fair market value of the property, and the taxpayer claimed a casualty loss deduction, which the IRS disallowed. The Tax Court, however, held that the taxpayer was entitled to the deduction. Because the damage in Helstoski was caused by a storm, and, under her theory, rainstorms caused the damage to the Castle Village retaining wall, Alphonso argued that Helstoski supported her casualty loss deduction for the collapse of the retaining wall.

The Tax Court found that Alphonso’s reliance on Helstoski was misplaced because of differences between that case and hers, particularly with respect to the expert witness testimony. In Helstoski, while the IRS took the position that the dam failure was due to gradual erosion around the dam footings, the IRS’s expert admitted that he was not certain why the dam had failed and that several factors were involved. Therefore, the Tax Court was unwilling to rely on the IRS’s explanation.

In Alphonso’s case, the court found the IRS expert’s report and testimony to be persuasive and reliable, while finding her expert’s report and testimony to be the opposite. The court noted that Alphonso’s expert, while being an expert in geotechnical engineering, opined in his report on matters outside this area, making only part of his report usable. At trial, he admitted he had used the wrong engineering guideline in his report, and the court found his testimony at trial was uninformed because he had not adequately reviewed his report before trial. Additionally, as the court discussed at some length, his answers under cross-examination by IRS counsel tended to contradict rather than support his conclusion about the cause of the collapse.

On the other hand, the court found the IRS’s expert witness to be fully qualified in all the subjects covered in his report, and described his report as “impressive and persuasive.” The report presented a theory, which the court considered plausible, that due to the way in which the wall had been constructed and unobservable flaws in the construction, tension slowly had been building up over the years, resulting in the collapse in 2005. In addition, in his report and under cross-examination by Alphonso’s counsel, the IRS expert convincingly explained why rainfall in the months before the retaining wall collapse was only a small contributing factor to the collapse.

Reflections

This case underlines the importance of thoroughly prepared and knowledgeable expert witnesses. Although arguably, based on the other evidence in the record, there was not much chance that any expert witness could have convinced the Tax Court that Alphonso’s theory about the cause of the retaining wall’s collapse was correct, her expert’s failure to present a persuasive report and testimony did nothing to help her. As the Tax Court put it: “We are unwilling to rely on the views of a purported expert who is at best careless and at worst not competent.”

Alphonso, T.C. Memo. 2016-130