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Posted on April 13th, 2014, by

ABSTRACT

This instructional case involves a dilemma faced by Rick and Joan Harrison on the due date of their Federal tax return as to the deductibility of a casualty loss. The loss is due to the failure of the hydronic heat system installed in their personal residence. The legitimacy of a deduction is further clouded as 1) they do not have the financial resources to replace the unit and 2) have joined a class-action lawsuit against the manufacturer. The Harrisons are not sure if the loss is deductible, and if so, which costs are deductible and in which tax year they should take the deduction. This case addresses the deductibility of individual casualty losses and the associated ethical issues taxpayers face when filing a tax return without sufficient knowledge of tax law.

 

Learning Objectives:

1)    Evaluate the qualifications of casualty losses within the IRS Code.

2)    Understand the amounts and timing of eligible deductible losses.

3)    Evaluate the ethical issues surrounding the taking of a deduction when taxpayers are not certain that it is allowable.

4)    Understand the difference between evading taxes and avoiding taxes.

 

Keywords: individual taxation; personal casualty loss; deduction; ethical dilemma

 

 

 

CASE

The time for filing their tax return had run out; the return had to be filed in the next couple of hours; a decision had to be made.  Were the losses to the Harrisons’ home deductible as casualty losses or not?  If so, how much was deductible?  Was it ethical to take the deductions or would doing so be tantamount to cheating on their income taxes?  Would taking the deduction make them tax avoiders or tax evaders?

 

It had been many years since the Harrisons had last taken an aggressive position in filing their tax return.  That position had triggered an IRS audit, and it took a couple of years to resolve the matter.  They’d won, but when all was said and done, had they even made minimum wage for their efforts, and was the additional stress it had added to their life been worth it probably not.

 

On the former tax return, research had convinced them that the tax position they had taken was undeniably correct.  This time it did not seem as clear.  In their minds, the research they had done did not produce a clear black or white answer; it seemed like a gray area that could go either way.

 

But this loss and its related possible tax consequences involved a lot more money, and they no longer had their peak income earning years in front of them.  They were starting to look towards the day they could retire.

 

Ten years had passed since Rick and Joan Harrison had bought their land.  The mobile home they had put on it was only temporary housing, but Joan kept asking just how long temporary lasted.  So, after years of saving, one spring a small crew was hired to help and they began to build on a shoestring budget.

 

To save money, they were their own architects and their own general contractors.  Rick and Joan did a lot of the work themselves, even the menial work of clean-up after construction ended each day.  In numerous decisions they opted for modest quality, but those were items that could be upgraded later when more money became available.  However, on windows and the heating system, they decided to go first class.

 

Hydronic heat was fashionable and was what was being installed in the top-end homes.  Of course, it cost more but it wasn’t practical to retrofit a home with it later on.  The tubing (hose) that would circulate the glycol (antifreeze) throughout the home would be an integral part of the concrete floor of the basement, garage, and north sloping driveway.  To heat the upper level, it would also be installed in the upstairs’ floor joists (i.e. the basement ceiling).  Possible future leaks had been a concern, but the plumbing subcontractor had convinced them that leaks just didn’t happen with the new high tech product that would be installed.  In addition, in the unlikely event that it did fail, the product carried a twenty-five year warranty from a huge, rock solid company listed on the New York Stock Exchange.  Besides, in the concrete floors, how could it leak?  After the concrete cured, the tubing would be permanently encased and there would be no place for the fluid to go.

 

Well, it had not worked out that way.  Just five years after being professionally installed by the subcontractor, one snowy mid-December evening in Year 1, Rick and Joan returned home to a cold house.  Noticeable leaks had rather suddenly appeared in several places on the basement ceiling below the living room.  Fortunately, the house had been built with five heating zones that operated independently of each other.  So, the leaking zone was quickly identified by Rick and turned off.  The next day, the rest of the system was recharged with fresh glycol and functioned fine, at least for a short time.

 

But, one at a time, other zones began to fail.  The second failure occurred just weeks later, shortly after New Year’s Day, in the basement family room where the heat system tubing had been embedded in the concrete floor.  Unlike the upstairs leaks that became obvious in the damaged sheetrock, the leaks in the downstairs floors never became visible.  The house had been built on a gravel bank, high above a river; apparently the fluid that leaked went down rather than up. That zone too was turned off.  Using small electric heaters and fans as supplements, made it possible to push warm air into the cooler areas of the house.  So, in this way, Rick and Joan were able to adequately heat the home.

 

However, as winter released its cold grip on Colorado, more failures forced them to completely shut down the hydronic system.  Fortunately, an early spring had brought warmer than normal temperatures.  So, while the house was not as warm as they would have liked, they dressed warmer and were able to get by with just the electric space heaters and fans without too much inconvenience.

 

Although the original plumbing contractor who had been so friendly and service-oriented when they had bought the system still lived in the area, he was out of the plumbing business and would not return calls.  Attempts to contact the manufacturer directly, hoping that it would come to their aid, proved fruitless.  Similarly, their insurance agent told them that their losses were not covered by their homeowners’ policy.  Reluctantly, the Harrisons turned to an attorney to seek advice.

 

It wasn’t long before their local lawyer had advised them to try to become a part of a class action suit being brought by a prestigious law firm in Denver.  At a cost of about $8,000, serious money for the Harrisons, the Denver attorneys eventually agreed to incorporate them in their suit whose primary clients were wealthy homeowners in Colorado ski country.

 

The attorneys required an engineering study as well as a written estimate from a contractor who was qualified to do the repairs.  The latter was quickly obtained and resulted in an estimate that was more than the Harrisons’ annual income and about fourteen times the cost of the original heating system.  The estimate was for more than $97,000.

 

For that amount, the contractor would remove all of the tubing that had been installed.  That would require jackhammering out the concrete basement floor, garage floor, and driveway; he would also rip out the basement ceilings’ sheetrock, insulation, and heat tubing.   After the demolition, the process would be reversed; the defective tubing would be replaced with another product that would serve the original purpose.

 

There were just a couple of problems.  Rick and Joan Harrison didn’t have the $97,000 or an amount even close to that.  Understandably, the contractor wanted assurance of being paid before the work began.  Agreeing to authorize the work would necessitate another mortgage that would postpone the homeowner’s scheduled retirement for many years to come.

 

After considerable discussion, Rick and Joan decided that they did not want to commit to taking out another mortgage and investing almost another $100,000 in a home that they had struggled to build for about $150,000.  But something had to be done.  Going without heat next winter in Colorado was not an option.

 

The Harrisons devoted considerable time in researching other heating systems including solar, forced air gas, and even wood.  Finally, during the summer, as a stop-gap measure until the lawsuit was resolved, the homeowners reluctantly opted to install centralized electric high efficiency heat stoves.  One was put in the basement recreation room and a second was installed in the upstairs dining room.  The total cost was about $6,000.

 

As had been expected, during the following winter, the electric heat stoves did not heat the house uniformly or provide the comfort they had become accustomed to with the in-floor hydronic heat.  However, some things were more important than their physical comfort.

 

Since the heat system problem had begun, other personal problems had unexpectedly taken center stage in their lives.  Joan’s widowed mom, Margaret, who lived in Idaho, twelve hours away by car, could no longer function independently.  Margaret’s doctor gave her a choice, move into a retirement center or go live with Joan, her only child, in Colorado.  So, after a rather stressful drawn out period of time, Margaret had recently become a part of their household, and her health problems had become their health problems.  At about the same time, as her only living relatives, the Harrisons were becoming increasingly responsible for Leone, an even older and more dependent senior who lived more than eight hours away in Phoenix, Arizona.

 

Too many obligations and problems, too little time; and, the deadline for filing their tax return was looming.  The Harrisons had to make decisions; the time for filing their tax return had run out; they had to file their return.  In his mind, the tax research Rick had done was inconclusive; it had not produced clear answers as to the amount and timing of what was and what was not deductible.  With those uncertainties, was it even ethical to take a deduction for the loss? But if they did not claim the deductions, would the possibility for doing so be lost forever?  Given the uncertainty about deductibility and the small percentage of tax returns that were known to be audited by the IRS, would it be foolish not to take the deduction or would betting on not being audited in itself be unethical?

 

If Rick and Joan were to claim the loss as a deduction, what amount would be deductible?  Several items and amounts seemed plausible to include in their return.

 

The cost of the system (boiler and tubing) as originally installed was $7,000.  They had incurred $8000 in out-of-pocket costs to-date for legal advice plus other charges in an attempt to get at least part of the original system to function.  The stop-gap electric heaters cost $6,000.  They had received an estimate of $5,000 to replace just the damaged insulation and sheetrock and then paint it.  The contractor’s bid to replace the damaged sheetrock, insulation and old heat system with an equivalent new one totaled $97,000.

 

Also, what about the stigma that might attach to the house?  From a real estate source, Rick and Joan had been advised that if they ever sold their home, a disclosure would have to be made that it had originally been heated with the defective product.  Would that stigmatize the home and result in an additional loss?  If so, how would that loss be measured?   Might that loss also be deductible?

 

When would the losses be deductible, in Year 1 when the first failure occurred, or, the following year by which time more failures had occurred and it had become obvious that there would be no inexpensive, quick easy fix?  Were the contractor estimates adequate evidence for deducting the losses, or would they have to wait to take the deductions until the actual costs of making the repairs were known with certainty?   Or, should they wait until the outcome of the lawsuit was determined?  If they waited, was there a time limit?

 

What would be required if the plaintiffs prevailed in the class action lawsuit?  If Rick and Joan took the loss as a deduction, might they later have to declare the award as taxable income?   In addition, what if they didn’t deduct the loss and then prevailed in the lawsuit, would the award be taxable or just treated as nontaxable damages?  What would you advise Rick and Joan to do?

 

END.

 

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