By John Stambaugh

When Robert and June Davis thought about building a new custom home, they never could have imagined it costing them more than $100,000 in additional tax, penalties and interest in U.S. Tax Court.

Here is the story.

In May 2000, they hired Mona Builders and Developers to build a custom home. The contract was for about $900,000. The contract between the Davises and Mona Builders contained the usual language about change orders, payments and professional care.

In August 2001, the Davises moved into the home.They soon discovered the workmanship was poor. Certain structural components were inferior to those required by the contract. Certain other structural components had not been installed at all. About a month after they moved in they asked Mona Builders to stop work on the house.

By December 2001, Mona Builders had sued the Davises for failure to pay the last $23,000 due on the contract, and the Davises had counter-sued, claiming Mona Builders breached the contract.

In May 2003, Mona Builders agreed to buy back the home from the Davises for $1.5 million. On Nov. 1, 2004, a jury awarded the Davises about $500,000 as additional compensation.

To understand how this sad tale cost the Davises so much money in U.S. Tax Court you have to understand a little about tax law and theft losses. The tax law allows, with certain, significant limitations, a deduction for any loss sustained during a taxable year not compensated by insurance. This is known as the theft loss deduction.

Generally, a deductible theft loss is limited to the lesser of the decline in fair market value of the property before the loss and zero (zero because the property is stolen) or the taxpayer's actual cost basis in the property. Cost basis means what the taxpayer put into the property.

When Mr. and Mrs. Davis filed their 2000 income tax returns, they claimed a theft loss deduction of about $250,000. This was based on what the Davises had paid Mona Builders during 2000 as the home was being built.

The tax law allows you to deduct a theft loss in the year you discover it. Robert Davis claimed in tax court testimony he discovered in 2000 Mona Builders over-charged him for bricks used to build his home and had charged him for brick never used to build his home. However, the tax law also requires you be able to prove when you discovered the loss.

The tax court judge found Robert Davis' testimony about how he had visited the brick dealer and recognized he had been significantly overcharged less than credible. The tax court judge also pointed out Robert Davis, in his lawsuit against Mona Builders, claimed he did not become aware of the overcharges until discovery was conducted as a result of his counter-claim lawsuit. The counter-claim lawsuit, the tax court judge pointed out, did not begin until December 2001.

Ultimately the tax court judge ruled the Davises had failed "to establish that they became aware of the alleged brick theft at any time in 2000." Accordingly, their income tax deduction of $250,000 was disallowed.

What we can learn from the Davises' loss in U.S. Tax Court is it is not enough to have been victimized and lost money, you must be able to prove when your loss happened in a credible and consistent manner. Otherwise, you will lose a second time when you lose the income tax deduction.

Stambaugh is a local certified public accountant with more than 18 years experience in business tax planning and tax preparation and a master's degree. He can be reached at 234-2438.

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