T.C. Summary Opinion 2016-28



                         UNITED STATES TAX COURT



     BARTON SLAVIN AND AMY WEINSTOCK SLAVIN, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 7785-12S.                          Filed June 21, 2016.



      Barton Slavin and Amy Weinstock Slavin, pro sese.

      Theresa G. McQueeney, for respondent.



                              SUMMARY OPINION


      GALE, Judge: This case was heard pursuant to the provisions of section

7463 of the Internal Revenue Code in effect when the petition was filed. Pursuant

to section 7463(b), the decision to be entered is not reviewable by any other court,

and this opinion shall not be treated as precedent for any other case.
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       Respondent determined the following deficiencies and accuracy-related

penalties under section 6662(a)1 with respect to petitioners’ Federal income tax for

taxable years 2007, 2008, and 2009 (years at issue):

                                                      Penalty
                         Year        Deficiency     sec. 6662(a)
                         2007           $3,066          $613
                         2008           11,792         2,358
                         2009           26,605         5,321

      After the parties’ concessions,2 the issues for our consideration are

(1) whether petitioners are entitled to mortgage interest expense deductions for




      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
      2
        For 2007 petitioners have conceded that they had unreported taxable
interest income, that they are not entitled to their claimed real estate loss deduction
in the amount that respondent has disallowed, and that respondent’s adjustments to
their claimed child tax credits are computational. For 2008 and 2009 petitioners
have conceded that they are not entitled to their claimed real estate loss deductions
in the amounts that respondent has disallowed and that the other adjustments,
including the taxation of State and local tax refunds, are computational. The
parties have also agreed that for 2009 petitioners had a $47,949 capital gain
taxable at the long-term capital gains rate. Respondent has conceded that
petitioners had reasonable cause for their failure to report the capital gain and that
they are not liable for the portion of the sec. 6662(a) penalty for 2009 attributable
to the capital gain adjustment.
                                         -3-

taxable years 2008 and 2009 and (2) whether petitioners are liable for accuracy-

related penalties under section 6662(a) for the years at issue.

                                     Background

      Some of the facts have been stipulated and are so found. The stipulated

facts are incorporated herein by this reference. Petitioners resided in New York

when the petition was filed. Petitioner husband is a litigation attorney who also

has experience with real estate transactions. Petitioner wife worked in sales,

helped with petitioners’ rental activity, and cared for their children during the

years at issue.

      During 2004 petitioners purchased from family friends (sellers) two semi-

detached houses in Rockville Centre, New York (collectively, property), as a

rental property. In lieu of obtaining third-party financing, on November 2, 2004,

petitioners executed a mortgage on the property and a promissory note for

$975,000 payable to the sellers. Under the terms of the promissory note,

petitioners were to make two interest-only payments per year representing an

annual interest rate of 6%3 until the maturity date in 2034, at which date the note

would be due in full. The interest payments were due in May and December each


      3
        As long as petitioners did not make principal payments, the semiannual
interest payments were to be $29,250.
                                         -4-

year. The May interest payments were to be applied to the unpaid interest for

November and December of the previous year and to the unpaid interest for

January through April of the current year. The December interest payments were

to be applied to the unpaid interest for May through October of the current year.

      Petitioners paid the sellers $54,000 of interest in 2007. However, the rental

property was not as profitable as petitioners had hoped, and they did not make any

payments on the promissory note for 2008 or 2009. On June 10, 2008, petitioners

and one of the sellers executed a mortgage modification agreement capitalizing

$54,000 of unpaid interest for 2008 into the unpaid mortgage principal.4 On

October 15, 2009, petitioners and one of the sellers executed a second mortgage

modification agreement capitalizing $54,000 of unpaid interest for 2009 into the

unpaid mortgage principal.5 Neither of the mortgage modification agreements

altered the 6% annual interest rate.

      After a series of conversations, the dates of which are not clear from the

record, petitioners and one of the sellers entered into an interest rate modification


      4
       The June 10, 2008, mortgage modification agreement stated that the unpaid
principal balance of the original promissory note was $980,000.
      5
       Although petitioners did not make any interest payments for 2008-09 and
although under the terms of the promissory note petitioners were to pay annually
$58,500 of interest spread over two payments, the mortgage modification
agreements addressed only $54,000 of unpaid interest for each year.
                                         -5-

agreement on January 8, 2010. Under the terms of this agreement, the annual

interest rate as set forth in the promissory note was reduced from 6% to 3%

effective January 1, 2008. The interest rate modification agreement did not

address how the agreement to retroactively reduce the interest rate affected the two

mortgage modification agreements or the mortgage principal.

      During the years at issue petitioners were cash basis taxpayers. They timely

filed joint Forms 1040, U.S. Individual Income Tax Return, for the years at issue.

Petitioners attached to each Form 1040 a Schedule E, Supplemental Income and

Loss, on which they reported that they were real estate professionals and claimed a

rental real estate loss deduction. On each Schedule E petitioners claimed, inter

alia, a mortgage interest expense deduction of $54,000. They did not submit into

evidence documentation sufficient to substantiate their status as real estate

professionals or their entitlement to the rental real estate loss deductions.

      Petitioners hired Mayeer Karkowsky, a certified public accountant who is

also an attorney admitted to the U.S. Tax Court Bar, to prepare their Forms 1040

for the years at issue. Mr. Karkowsky appeared and testified at trial. He discussed

with petitioner husband before the filing of the Forms 1040 the mortgage interest

expense deductions for the years at issue, but he did not have either mortgage

modification agreement or the interest rate modification agreement when he was
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preparing the returns. He advised petitioner husband that, because of the

capitalized interest and the interest rate reduction, petitioners’ mortgage had been

“substantially modified” under section 1.1001-3, Income Tax Regs., and therefore

petitioners qualified for the mortgage interest expense deductions.

      Respondent issued to petitioners a notice of deficiency dated January 3,

2012, for the years at issue. Petitioners timely filed a petition for redetermination

of the deficiencies.

                                     Discussion

I.    Burden of Proof

      Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and the taxpayer bears the burden of proving that those

determinations are erroneous. Rule 142(a)(1); Welch v. Helvering, 

,

115 (1933). The taxpayer likewise bears the burden of proving his entitlement to

deductions allowed by the Code and of substantiating the amounts of expenses

underlying claimed deductions. Sec. 6001; INDOPCO, Inc. v. Commissioner, 

, 84 (1992); sec. 1.6001-1(a), Income Tax Regs. Under section 7491(a), in

certain circumstances, the burden of proof may shift from the taxpayer to the

Commissioner. Petitioners have not claimed or shown that they meet the
                                         -7-

requirements of section 7491(a) to shift the burden of proof to respondent as to

any relevant factual issue.

II.   Mortgage Interest Expense Deductions

      Petitioners did not make any payments toward the promissory note for 2008

or 2009. Rather, the two mortgage modification agreements each capitalized

$54,000 of unpaid interest into the mortgage principal. Petitioners claimed on

their 2008 and 2009 Schedules E mortgage interest expense deductions for the

amounts of the capitalized interest. Respondent disallowed the claimed

deductions.

      Section 163(a) provides that there shall be allowed as a deduction all

interest paid or accrued within the taxable year on indebtedness. Cash basis

taxpayers, such as petitioners, are allowed a deduction for interest paid during the

taxable year in cash or its equivalent. See Don E. Williams Co. v. Commissioner,

, 577-578 (1977); Davison v. Commissioner, 

, 41 (1996),

aff’d, 

 (2d Cir. 1998); Menz v. Commissioner, 

, 1185

(1983). When a lender capitalizes unpaid interest by adding the unpaid interest

amount to the loan principal, a cash basis borrower is not entitled to a current

interest deduction for the interest that is added to the loan’s principal balance.

Heyman v. Commissioner, 

, 485-487 (1978), aff’d, 

 (6th
                                         -8-

Cir. 1980). Petitioners did not pay mortgage interest for 2008 or 2009 in cash or

its equivalent. The mortgage modification agreements did not constitute interest

payments but rather allowed petitioners to postpone the paying of interest. As

cash basis taxpayers, they are not entitled to deductions for the interest that was

capitalized into the unpaid mortgage principal.

      Petitioners attempt to distinguish the above-cited caselaw by contending

that the capitalization of the 2008-09 interest was a true discharge of the interest

because there was a “substantial modification” of the promissory note under

section 1.1001-3, Income Tax Regs. Even if we were to accept petitioners’ theory

that there was a “substantial modification” of the promissory note for 2008-09,

which we do not, that theory does not help them. Section 1.1001-3, Income Tax

Regs., addresses when a modification of the terms of a debt instrument results in

recognition of gain or loss under section 1001. It does not concern the

deductibility of interest payments.

      Moreover, Allan v. Commissioner, 

 (8th Cir. 1988), aff’g 

 (1986), which petitioners cite in support of their case, is distinguishable.

That case concerned accrual basis taxpayers, which petitioners are not, and

addressed whether capitalized interest was properly includible in the taxpayers’

amount realized upon foreclosure of the mortgaged property. See Smoker v.
                                         -9-

Commissioner, T.C. Memo. 2013-56, at *12-*13 (explaining that Allan does not

support a cash basis taxpayer’s claimed deduction for unpaid interest that was

capitalized into the principal of the loan).

       As cash basis taxpayers, petitioners were not entitled to deduct unpaid

interest that was capitalized in the mortgage principal. We sustain respondent’s

disallowance of petitioners’ mortgage interest expense deductions for 2008-09.

III.   Section 6662(a) Accuracy-Related Penalties

       Respondent determined that petitioners are liable for accuracy-related

penalties pursuant to section 6662(a)for the years at issue. The Commissioner

bears the burden of production regarding a taxpayer’s liability for any penalty.

Sec. 7491(c); see Higbee v. Commissioner, 

, 446-447 (2001). Once

the Commissioner has met this burden, the taxpayer must provide persuasive

evidence that the Commissioner’s determination was incorrect. See Rule 142(a);

Higbee v. Commissioner, 116 T.C. at 447.

       Section 6662(a) and (b)(1) imposes a 20% penalty on any portion of an

underpayment of tax required to be shown on a return attributable to negligence or

disregard of rules or regulations. The term “negligence” includes any failure to

make a reasonable attempt to comply with the provisions of the internal revenue

laws, including any failure to maintain adequate books and records or to
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substantiate items properly, and the term “disregard” includes any careless,

reckless, or intentional disregard. Sec. 6662(c); sec. 1.6662-3(b)(1) and (2),

Income Tax Regs. Negligence is strongly indicated where a taxpayer fails to make

a reasonable attempt to ascertain the correctness of a deduction, credit, or

exclusion on a return that would seem to a reasonable and prudent person to be

“too good to be true” under the circumstances. Sec. 1.6662-3(b)(1)(ii), Income

Tax Regs.

       Petitioners conceded, inter alia, that respondent’s adjustments with respect

to their unreported interest income for 2007, their rental real estate loss

deductions, and their State and local tax refunds were correct. They also failed to

maintain adequate records showing their entitlement to the claimed rental real

estate loss deductions for the years at issue. Moreover, petitioners, especially

given petitioner husband’s background and education level, should have known

that, as cash basis taxpayers, they were not entitled to deduct unpaid interest.

Respondent has met his burden of production with regard to the imposition of

accuracy-related penalties for the years at issue.

      Taxpayers may avoid liability for the section 6662 penalty if they

demonstrate that they had reasonable cause for the underpayment and that they

acted in good faith with respect to the underpayment. Sec. 6664(c)(1).
                                        - 11 -

Reasonable cause and good faith are determined on a case-by-case basis, taking

into account all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income

Tax Regs. Generally, the most important factor is the extent of the taxpayer’s

efforts to assess his proper tax liability. Id. Circumstances that may indicate

reasonable cause and good faith include an honest misunderstanding of fact or law

that is reasonable in light of all of the facts and circumstances, including the

experience, knowledge, and education of the taxpayer. Id.

      Reliance on professional advice may constitute reasonable cause and good

faith, but “it must be established that the reliance was reasonable.” Freytag v.

Commissioner, 

, 888 (1987), aff’d on another issue, 

(5th Cir. 1990), aff’d, 

 (1991). The taxpayer’s education,

sophistication, and business experience will be relevant in determining whether

the taxpayer’s reliance on tax advice was reasonable and in good faith. Sec.

1.6664-4(c)(1), Income Tax Regs.

      Petitioners argue that they acted in good faith by relying on professional

advice. Although petitioners demonstrated that their adviser was a competent

professional with sufficient experience to justify reliance, see Neonatology

Assocs., P.A. v. Commissioner, 

, 99 (2000), aff’d, 

 (3d

Cir. 2002), we are not convinced they had reasonable cause and acted in good
                                          - 12 -

faith. First, nothing in the record indicates that petitioners sought or relied on

advice from Mr. Karkowsky with respect to the adjustments that they have

conceded. See id. Second, with respect to the mortgage interest expense

deductions, petitioners have not proven that their reliance on Mr. Karkowsky was

reasonable. Although petitioner husband had discussed the mortgage interest

expense deductions with him, Mr. Karkowsky did not have the two mortgage

modification agreements or the interest rate modification agreement when he

prepared the returns. See id. (stating that taxpayers must provide necessary and

accurate information to their adviser).

      Moreover, petitioners’ reliance on Mr. Karkowsky’s theory of the

deductibility of the interest was not reasonable. Even if petitioners did not

understand that section 1.1001-3, Income Tax Regs., was not applicable to their

situation, petitioner husband understood that Mr. Karkowsky’s advice was at least

partially based on the interest rate reduction from 6% to 3%.6 However, on each

of their 2008-09 Forms 1040, petitioners deducted mortgage interest expenses of

      6
        Although the interest rate modification agreement was not executed until
January 2010, we give petitioners the benefit of the doubt and assume, without
deciding, that they and the sellers had orally agreed to the interest rate reduction
before Mr. Karkowsky prepared petitioners’ 2008 Federal income tax return. If
there was no oral agreement before Mr. Karkowsky prepared petitioners’ 2008
Federal income tax return, petitioners’ reliance on Mr. Karkowsky’s advice for
their 2008 mortgage interest deduction would also be unreasonable.
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$54,000. This is the same amount of interest that petitioners had deducted for

2007, when the interest rate was 6%. Especially given petitioner husband’s

education level, petitioners should have realized that an interest rate reduction

would have translated into a smaller mortgage interest expense deduction for the

year. Petitioners have failed to prove that they had reasonable cause or that they

acted in good faith, and they are liable for the section 6662(a) penalties for 2007

and 2008 and for the penalty for 2009 in excess of the amount that respondent has

conceded.

IV.   Conclusion

      We have considered the parties’ remaining arguments, and to the extent not

discussed above, conclude those arguments are irrelevant, moot, or without merit.

      To reflect the parties’ concessions and the foregoing,


                                                 Decision will be entered

                                       under Rule 155.