With the filing deadline for individuals to file their income tax returns approaching and people becoming more acutely aware of how much in taxes they will pay for the last year, now, perhaps more than other times of the year, I receive comments from people about “starting an LLC to reduce taxes,” or “having expenses that I’d like to write off,” or best of all “I saw on social media….” Regarding the last comment, and largely outside the scope of this article, taxpayers should be especially weary of tax “advice” found on social media. As written about in my colleague Devin Mills’ most recent article[1] on the Internal Revenue Service’s 2025 Dirty Dozen, outright incorrect, and sometimes fraudulent, tax “advice” is prevalent on social media, and unfortunately the burden of any action taken based on this social media “advice” will fall on the taxpayer rather than the social media “influencer” who gave such “advice.”
While presumably all taxpayers would like to reduce or mitigate their tax liability to the greatest extent they can, taxpayers should only take deductions that (1) are permissible under the Internal Revenue Code and the regulations thereunder, and (2) can be substantiated by the respective taxpayer. Substantiation of positions taken on a respective tax return, particularly regarding deductions taken, have been written about frequently by my colleagues and me[2], and here again, in a recent Memorandum Opinion by the U.S. Tax Court, we see a case where deductions were taken and subsequently disallowed because the taxpayer’s inability to substantiate the same.[3]
Facts
The Internal Revenue Service (“IRS”) issued the taxpayer a Notice of Deficiency in 2021, determining a deficiency in the taxpayer’s 2018 federal income tax, as well as assessing a penalty under Section 6651(a) for failure to file an income tax return and failure to pay tax. The taxpayer and IRS had agreed to almost all issues related to the 2018 tax year prior to the Tax Court’s review, which only considered whether the taxpayer was entitled to a depreciation deduction claimed on his 2018 return.
The taxpayer, a California resident, and the taxpayer’s brother, purchased a home in Los Angeles in 2002. The home was secured by a mortgage and, in 2011, presumably to help his brother, the taxpayer assumed the outstanding balance on the loan. Several years thereafter, the taxpayer’s brother deeded an interest in the residence to the taxpayer as a tenant-in-common. The property was first held out for rent and rented in 2017 (although the pleadings before the Tax Court do not stipulate whether the Taxpayer’s brother or a third party was the tenant, nor does the Tax Court consider such in its opinion).
While the taxpayer’s 2018 federal income tax return was due in 2019 (and no extensions were filed), the taxpayer did not submit such return until March 11, 2024, approximately five years after the due date and two and a half years after the IRS had issued the relevant Notice of Deficiency.
Law
As cited and stated in nearly every case involving the substantiation of deductions, deductions are a matter of legislative grace and the taxpayer bears the burden of proving entitlement to any deductions claimed.[4] Section 167(a) allows as a depreciation deduction a reasonable allowance for the exhaustion and wear and tear of property held for the production of income. To be entitled to a depreciation deduction, a taxpayer must substantiate the property’s depreciable basis by showing its cost, its useful life, and any previously allowed or allowable depreciation.[5]
In the present case, the property was not originally used for the production of income, as the Taxpayer’s brother used it as his primary residence, and the taxpayer did not begin renting the house until 2017, years after his brother deeded an interest in the property to him. The basis for depreciating the property is governed under Treas. Reg. 1.167(g)-1, which provides that generally the basis for depreciation allowance is the adjusted basis of the property[6], but in the case of property which has not been used in a trade or business or held for the production of income but is converted to such use thereafter, the basis for depreciation allowance will be the lesser of (i) the fair market value on the date the property was converted for the production of income, or (ii) the adjusted basis of the property.
Outcome
The Tax Court expressly stated that the taxpayer “did the best he could under the circumstances” to estimate the property’s fair market value and adjusted basis at the time of the conversion of the property for production of income. Unfortunately for the taxpayer, the Tax Court found the evidence he offered to substantiate those amounts lacking. The taxpayer used open real estate valuation sources to value the fair market value of the property as of 2017, but the Tax Court found that such “guestimate” did not satisfy the “precision required by Section 167 and Treasury Regulations 1.167(g)-1.” Further, the Tax Court went on to state that even if they accepted such “guestimate,” the circumstances regarding his acquisition of the real property from his brother left too much uncertainty to allow the necessary computation of the property’s basis. Having been found to not be able to compute the basis of the relevant property, the Tax Court accurately determined that the taxpayer could not establish that the depreciation deduction claimed was the lesser of the (i) fair market value or (ii) adjusted basis of the property under Treas. Reg. 1.167(g)-1, and therefore held the taxpayer was not entitled to the depreciation deduction on his untimely 2018 tax return.
Conclusion
While not novel, this case again illustrates the importance and necessity of a taxpayer’s ability to substantiate all positions taken on his or her return. This case also particularly highlights the importance of timely filing an accurate return, as the Tax Court expressly opined, “Given the many items agreed to between the parties, we suspect that if the return had been timely filed, then this case would not have materialized.” Given the current tax season, many taxpayers are looking for ways to mitigate their federal tax liability. This case should serve as a gentle reminder to (1) file a return on time, and (2) be able to substantiate all positions taken on such return, even if aggressive. The consequences of failing to do so can far outweigh any short-term reduction of tax liability for a given year.
[1] https://esapllc.com/2025-dirty-dozen-list/
[2] https://esapllc.com/weston-case-deductions-2025/; https://esapllc.com/substantiate-those-deductions-but-not-with-falsified-documents-chopra-2025/; https://esapllc.com/theft-loss-shaut-case-2024/
[3] Sherman Derell Smith v. Comm’r, T.C. Memo 2025-24 (2025).
[4] INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
[5] Cluck v. Comm’r, 105 T.C. 324, 337 (1995).
[6] As provided in Section 1011 for the purpose of determining gain on the sale or other disposition of such property.
