This article examines the Tax Court’s decision in Sherman Derell Smith v. Commissioner, T.C. Memo. 2025-24, which serves as a crucial reminder for tax practitioners regarding the substantiation requirements for depreciation deductions, particularly for property converted to income-producing use. The case highlights the taxpayer’s burden of proof and the specific rules governing the basis of converted property for depreciation purposes.

Facts of the Case

In Smith, the petitioner, Sherman Derell Smith, sought a depreciation deduction on his 2018 federal income tax return for a rental property located in Los Angeles, California. The property was initially purchased by the petitioner’s brother in 2002 and used as his residence. Subsequently, in 2011, the petitioner assumed the outstanding balance on the loan secured by a mortgage on the property. Several years later, the brother conveyed an interest in the rental property to the petitioner as a tenant-in-common. According to the petitioner, the rental property was first held for rent and rented in 2017.

The petitioner’s 2018 federal income tax return, originally due on April 15, 2019, was not submitted to the Commissioner of Internal Revenue (Respondent) until March 11, 2024, after the issuance of a Notice of Deficiency (Notice) dated November 8, 2021, and the filing of the Petition. While the parties resolved all other issues raised in the Notice, the court was left to consider the petitioner’s entitlement to a depreciation deduction claimed on a depreciation schedule attached to Schedule E, Supplemental Income and Loss, included with the untimely filed return. The court noted that the numerous agreements between the parties suggested that the case might not have arisen had the return been filed on time.

Taxpayer’s Request for Relief

The sole issue before the Tax Court was the petitioner’s entitlement to a depreciation deduction claimed on his 2018 federal income tax return. The petitioner had calculated a depreciation deduction for the rental property, attempting to estimate both its fair market value and depreciable basis at the time of conversion to rental use.

Court’s Analysis of the Law

The Tax Court began its analysis by reiterating the fundamental principle that deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any deductions claimed. This principle is supported by Rule 142(a) of the Tax Court Rules of Practice and Procedure and the Supreme Court’s decisions in INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992), and New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

The court then turned to the specific requirements for a depreciation deduction under section 167(a) of the Internal Revenue Code, which allows a "reasonable allowance for the exhaustion and wear and tear of property held for the production of income". To be entitled to this deduction, a taxpayer must substantiate the property’s depreciable basis by showing its cost, its useful life, and any previously allowed or allowable depreciation, citing Cluck v. Commissioner, 105 T.C. 324, 337 (1995).

Crucially, the court addressed the rule applicable to property that was not originally held for the production of income but is subsequently converted to such use. In such cases, Treasury Regulation § 1.167(g)-1 dictates that the property’s basis for computing depreciation is the lesser of the fair market value or the adjusted basis on the date of such conversion.

Application of the Law to the Facts

In applying the relevant legal principles to the facts of Mr. Smith’s case, the Tax Court found that while the petitioner attempted to estimate the rental property’s fair market value and adjusted basis at the time of conversion, the evidence he offered to establish these amounts for the purpose of comparison was lacking.

Regarding the fair market value, the court noted that the petitioner used real estate valuation sources available in 2024 to estimate the property’s value at the time of conversion in 2017. The court deemed this estimate, at best, a "guestimate" that did not satisfy the precision required by section 167 and Treasury Regulation § 1.167(g)-1.

Furthermore, the court found the petitioner’s proof regarding the rental property’s basis to be insufficient. The circumstances surrounding his acquisition of an interest in the property from his brother left "too much uncertainty to allow for the necessary computation of the rental property’s basis".

Ultimately, the Tax Court concluded that the petitioner failed to establish that the depreciation deduction in dispute was calculated by taking into account the lesser of (1) the rental property’s fair market value or (2) his basis in the rental property.

Court’s Conclusion

Based on the petitioner’s failure to adequately substantiate the fair market value or adjusted basis of the rental property at the time of its conversion to rental use, the Tax Court held that he was not entitled to the depreciation deduction shown on his untimely 2018 federal income tax return. The court indicated that a decision would be entered under Rule 155 to reflect this holding and the agreement between the parties on other matters.

Implications for Tax Practitioners

The Smith case underscores several critical points for tax practitioners:

Taxpayer’s Burden of Proof: CPAs must continually remind clients that claiming deductions requires proper substantiation. The burden of proof rests squarely on the taxpayer.
Depreciation of Converted Property: When dealing with property converted from personal to income-producing use, understanding and applying the "lesser of" rule for determining the depreciable basis (fair market value or adjusted basis at the time of conversion) is paramount.
Contemporaneous Documentation: This case highlights the challenges of reconstructing values and basis years after the fact. Encouraging clients to maintain thorough records at the time of conversion is essential. This includes appraisals or other reliable methods for determining fair market value and documentation supporting the original cost and any subsequent adjustments to basis.
Importance of Timely Filing: While not the central issue, the court’s observation regarding the late filing serves as a reminder of the potential for increased scrutiny and the loss of opportunities for resolution when returns are not filed timely.

In conclusion, Smith v. Commissioner provides a clear illustration of the importance of adhering to the specific rules and substantiation requirements for depreciation deductions, particularly when dealing with converted property. Tax practitioners should leverage this case to educate clients on their responsibilities and ensure proper documentation is maintained to support such deductions.

Prepared with assistance from NotebookLM.