Like the movie franchise, home is where our story begins. But in this case (Forde, Docket No. 1280-16), the thieves owned the home.
The taxpayer and his wife purchased the home in 1998 for $835,000. Over the next few years, through 2001, the taxpayer demolished the main home and constructed a new one.
During this time, the taxpayer owned an online tutoring company that was sued by the Securities and Exchange Commission for making false and misleading statements and omitting material information in securities filings.
Due to the financial difficulties caused by the lawsuit, the taxpayer was in danger of losing the home, and was unable to refinance his mortgage. He filed for bankruptcy protection in May 2001.
After filing bankruptcy, the taxpayer engineered a sale of the home. The transaction closed in June 2002. The contract called for a sales price of $5,995,000, a down payment of $550,000, a first mortgage of $3,896,750, and a promissory note from the buyer in the amount of $1,498,750. An addendum to the contract provided for approximately $477,000 of funds that the taxpayer would receive at closing to be placed in a separate account as a “move-in and fix-up allowance” for the buyer.
Amounts paid out of the closing included a sales commission of $359,700, legal fees of $24,000, and $5,995 of unspecified costs that the IRS agreed were additional basis to the taxpayer.
When the bankruptcy trustee looked into the sale, the transaction turned out to be part of a mortgage fraud scheme.
— The buyer who received the $3,896,750 mortgage was a friend of the taxpayer.
— The sale price was fictitious.
— The down payment the lender was told would be made was not in fact made.
— Neither the taxpayer nor the buyer actually intended to repay the note the buyer executed in favor of the taxpayer for the balance of the purchase price.
— The mortgage that some of the purchase price was supposed to pay off did not actually exist.
— Part of the loan proceeds were paid to the taxpayer, who used the borrowed funds to pay the mortgage of the lender from whom they had been borrowed.
— The taxpayer remained in the house after the sale. The buyer never took possession. The buyer did not make payments on the note to the taxpayer, and the taxpayer did not pay rent for his retained possession after the sale.
Payments toward the new lender’s mortgage loan were made for some time from the borrowed funds, and the scheme went on from December 2001 to January 2004. Eventually the mortgage went into default, the bankruptcy proceedings were converted to Chapter 7, and civil and criminal actions were brought against the taxpayer. He was convicted in 2009 and sentenced to 42 months in prison.
When the mortgage went into default, the lending bank took back the property and sold it at a loss of approximately $1.1 million.
The taxpayer filed his 2002 federal income tax return in April 2012 (nine years late). He claimed married filing separately as his tax status, and did not report any gain from the sale of the home. He contended that his basis in the home exceeded the amount realized from the sale transaction.
The IRS said the taxpayer should have reported a capital gain, and the tax court agreed.
Based on the numbers above, how much capital gain did the IRS calculate?
Note: As a starting point, the taxpayer and the IRS agreed the sales price was $3,986,750.
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The IRS examined the 2002 return and determined that the taxpayer realized capital gain on the sale in the amount of $2,422,055, taking into account the stipulated sale price ($3,896,750) minus (a) the taxpayer’s 1998 acquisition cost of $835,000, (b) closing costs of $389,695 (consisting of the commission, the attorney fees, and the unspecified additional amount), and (c) the section 121 exclusion of $250,000.
Editorial note: The $2,422,055 was the amount in the initial deficiency notice. The court allowed some additional basis for which the taxpayer provided substantiation.