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District Court Denies Deductions for Losses from Bad Real Estate Deal

(Parker Tax Publishing September 2017)

A district court held that a couple who invested in a real estate development that later turned out to be fraudulent were not entitled to refunds for losses sustained directly and through a partnership. According to the court, the couple did not meet the deductibility requirements provided in Rev. Proc. 2009-20, failed to show that there was no reasonable expectation of recovery in the year the losses were discovered, and did not satisfy the procedural requirements to bring a refund action for the partnership losses. Hamilton v. U.S., 2017 PTC 415 (N.D. Ind. 2017).


Robert Hamilton and his wife, Joan, were approached in 2006 with a real estate investment opportunity in North Carolina called the Grandfather Vista Development. The couple were told that for $500,000, they could buy a 10 acre lot and simultaneously enter into a buyback agreement effective one year after the purchase, by which the developers would repurchase the lot for $625,000. The developers personally guaranteed the buyback agreement, and represented to the Hamiltons that they had over $100 million in net worth. In other words, they portrayed the investment as nearly risk free.

The Hamiltons made a $25,000 down payment on one 10 acre lot referred to as Lot 86. The rest of the purchase price was financed through a bank, which disbursed the proceeds directly to the developers. At closing, the developers paid the Hamiltons $38,000 for the first year's interest on the loan. A short time after buying Lot 86, the Hamiltons purchased a second, smaller parcel in the development. This lot was represented to be a retail lot that would be developed after the commercial development was completed. For this purchase, the Hamiltons invested through a partnership called H-Cubed Enterprises, LLC. The two members of H-Cubed were an entity owned by the Hamiltons and an entity owned by their in-laws, Gregory and Cynthia Hellmann. H-Cubed bought Lot 135 for $275,000. The entire amount was financed, so the Hamiltons paid nothing at closing, but they signed notes personally guaranteeing the loan.

The developer failed to follow through on the buyback agreements and the property was never developed. The lots, which could not be developed individually, ended up being worth very little. The Hamiltons were thus left with large loans that were secured by property of little value. The Hamiltons stated that they discovered the fraudulent nature of the project in 2008. That same year, the state shut down the Grandfather Vista development. In December 2008, the Hamiltons and other purchasers filed suit against the developers and the banks that financed the loans. They also joined at least two adversary proceedings in bankruptcy court against some of the developers. Ultimately, the Hamiltons declared bankruptcy, through which they discharged their loan obligations arising from these investments. The Hamiltons ended up with outright ownership in Lot 86 and transferred their interest in Lot 135 to the Hellmanns.

In 2011, the Hamiltons met with an accountant to address the tax implications of their investment losses. They filed amended returns for 2008 to claim their losses as theft losses. The Hamiltons calculated their total investments in the properties, including the amounts they borrowed but never had to pay back, and claimed 75 percent of those amounts as theft loss deductions pursuant to Rev. Proc. 2009-20, which generally permits a 75 percent deduction for certain theft losses from Ponzi schemes. They claimed a loss on Lot 86 of approximately $361,000. With respect to Lot 135, the Hamiltons claimed a loss of $103,000, equal to half of the approximately $206,000 loss that H-Cubed identified on its return as a theft loss. The partnership losses were different from what the Hamiltons and H-Cubed had reported on their initial returns, so they filed amended returns to reflect those changes, but did not file an administrative adjustment request (AAR). An AAR is the process for amending the reporting of partnership items on a previous return.

For 2008, the Hamiltons sought a refund of $21,000, and sought to carryback loss deductions of $76,000 to 2005. The IRS disallowed the loss deductions and denied the Hamiltons' refund claim. According to the IRS, (1) 2008 was not the proper year to take the deductions for the Lot 86 losses, and (2) the district court did not have jurisdiction to consider the refund claims related to the partnership losses on Lot 135. The Hamiltons then filed a refund action in a district court.

Under Code Sec. 165, theft losses are generally deductible in the year the theft is discovered, but not if the taxpayer has a claim for reimbursement with a reasonable prospect of recovery. A good faith effort to recover the loss, such as a lawsuit, generally delays the deduction to a later year. For Ponzi scheme losses, Rev. Proc. 2009-20 provides a safe harbor procedure that allows a deduction of 75 percent of a loss in the year that criminal charges are filed against the lead figure in the scheme, if certain requirements are met. One of those requirements is that there must be a qualified loss in a qualified investment, as those terms are described in Rev. Proc. 2009-20.

Partnership losses are covered by the Tax Equity and Fiscal Responsibility Act (TEFRA), which requires that all adjustments to partners' tax liabilities and any challenges to these adjustments be determined by the IRS in a single partnership administrative proceeding. TEFRA limits the jurisdiction of district courts to hear an action for a refund involving partnership items. District courts have jurisdiction over refund actions for partnership items only if (1) the refund claim is based on a computational error, or (2) the partner's AAR is rejected by the IRS.

District Court's Analysis

The district court held that the Hamiltons were not entitled to any of the refunds they sought. With respect to Lot 86, the court determined that (1) the Hamiltons were not entitled to relief under Rev. Proc. 2009-20, and (2) they failed to show that there was no reasonable expectation of recovery in 2008. The Hamiltons did not meet the requirements under Rev. Proc. 2009-20, the court said, because they did not provide any evidence that they had a qualified loss from a qualified investment. The court found that although state authorities had shut down the Grandfather Vista project in 2008, there was no evidence that criminal charges were brought as a result of the conduct that caused the Hamiltons' loss. Thus, the loss suffered by the Hamiltons was not a qualified loss, the court found. Moreover, the court observed, the Hamiltons failed to establish that their investment was a qualified investment because any amount that was borrowed and not repaid could not have been borrowed from a party that was part of the fraud. The court found that the Hamiltons failed to show that the bank from which they borrowed the investment funds was not part of the fraud, so their investment was not a qualified investment.

The Hamiltons also did not meet the requirements for a theft loss under Code Sec. 165, in the court's view, because they filed suit in December 2008 against the developers and banks involved in their purchase of Lot 86 and continued to pursue that and other actions for several years. According to the court, the Hamiltons made no attempt to prove that these proceedings offered no reasonable prospect of recovery. The court noted that, in a year where the prospect of recovery is simply unknowable, a theft loss deduction is inappropriate.

For the losses on Lot 135 that the Hamiltons incurred through H-Cubed, the district court determined that it did not have jurisdiction to consider the refund because the Hamiltons did not demonstrate either a computational error or that their AAR was denied. The court found that there was no question that the theft loss deduction for the loss incurred through H-Cubed was a partnership item, and as such, the refund claim had to be resolved through TEFRA procedures. The court rejected the Hamiltons' contention that the amended return of H-Cubed was functionally equivalent to an AAR, holding that even if it were, a partnership's AAR does not confer jurisdiction on the district court. Only a partner's AAR, which is rejected by the IRS, gives rise to jurisdiction over a refund action.

For a discussion of the theft loss deduction, see Parker Tax ¶98,110. The TEFRA procedures are discussed at Parker Tax ¶28,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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