Prepare a research memo for the following situation. See page 380, Figure 11-2 in Chapter 11 for proper formatting.

Your client came home one day to find significant water damage in her home. One of the hoses from her washing machine had worn out and split, spilling water all over the place. Over the next month, mildew and mold appeared as well. Is there any casualty-loss deduction for your client? They did not have any homeowners insurance.

Figure 11-2 Example:

The Research Memo EXHIBIT 11-2: Sawyers and Gill CPAS San Francisco, CA September 30, 20XX Facts The Browns live in South Dakota. They own their home and hold investments in the debt of several domestic corporations. The interest that they received on this debt was gross income to them. To diversify their portfolio, the Browns took out a sizable second mortgage on their home and applied a portion of the proceeds to some City of Chandler school bonds. The remainder of the proceeds was used to expand the facilities of Mrs. Brown's dental clinic. Issue(s) How much of the mortgage interest paid can be claimed as an itemized deduction by the Browns? Conclusion That portion of the mortgage proceeds applied to the dental clinic generates an interest deduction to be claimed against clinic income on Schedule C. No other deduction is allowed Authorities IRC Section 265(a)(2) Rev.Proc. 72-18, 1972-1 C.B. 740 Wisconsin Cheeseman v. U.S., 388 F. 2d 420 Bradford, 60 T.C. 253 sraelson v. U.S., 367 F. Supp. 1104 Mariorenzi v. Comm., 490 F.2d 92, TC Memo 1973-141 PLR 8631006 Analysis and Summary The IRC disallows the deduction of interest on indebtedness that is incurred or continued to purchase or carry obligations, the interest on which is exempt from the federal income tax. IRC 265(a)(2). This provision denies the double benefit that would be enjoyed by the taxpayer who would receive tax-exempt income while simultaneously claiming an investment- interest deduction for the interest expense paid, for example, by incurring a bank loan and using the proceeds to purchase municipal bonds The IRS examines evidence to infer the intent of the taxpayer who is incurring the indebtedness. Under Rev. Proc. 72-18, 1972-1 C.B. 740, a taxpayer who purchases exempt bonds can claim an interest deduction if the debt in question has been incurred (1) for personal reasons (e.g., via a mortgage to finance the purchase of residential property), or (2) for valid business reasons, as long as the borrowing does not exceed legitimate business needs Several court decisions have emphasized that the existence of such business motives must be documented clearly, as to both presence and amount. Wisconsin Cheeseman v. U.S., 388 F.2d 420 (CA-7, 1968); Bradford, 60 T.C. 253 (1973); on v. U.S., 367 F. Supp. 1104 (D. Md. 1973). Is Mortgage indebtedness is a classic illustration of an investment that will generate deductible interest expenses for the tax- payer who holds exempt bonds. However, the timing of such a mortgage transaction must be monitored to exhibit the proper motives for the benefit of the IRS. In one case, the taxpayer paid for his home with cash. Only later was an invest- ment program (that included municipal bonds) initiated and a residential mortgage secured. The IRS inferred that the mort- gage proceeds were in indirect support of the exempt indebtedness, and the deduction for the mortgage interest was disallowed. Mariorenzi v. Comm., 490 F.2d 92 (CA-8, 1974), T.C. Memo 1973-141. Had the taxpayer secured a mortgage before the home was completed, purchasing the exempt bonds out of savings, it appears that the deduction could have been preserved. The IRS has applied this doctrine outside of the Eighth Circuit, in PLR 8631006 Because the Browns live in the Eighth Circuit, the Mariorenzi doctrine prevails, and no itemized deduction is allowed at all, that is, for that portion of the loan that is applied to the school bonds. Rev. Proc. 72-18 is insensitive to portfolio- diversification motives, and no personal motive appears to exist that supports any other possible deduction. According to the logic of these precedents, the Browns should have sold the exempt bonds and then used the proceeds to finance their portfolio acquisitions. Actions to Be Taken Prepare letter, review results with client Suggest changes in portfolio holdings to regain the deduction. Preparer: Mary H. Polzin Reviewer: Char E. Mano The Research Memo EXHIBIT 11-2: Sawyers and Gill CPAS San Francisco, CA September 30, 20XX Facts The Browns live in South Dakota. They own their home and hold investments in the debt of several domestic corporations. The interest that they received on this debt was gross income to them. To diversify their portfolio, the Browns took out a sizable second mortgage on their home and applied a portion of the proceeds to some City of Chandler school bonds. The remainder of the proceeds was used to expand the facilities of Mrs. Brown's dental clinic. Issue(s) How much of the mortgage interest paid can be claimed as an itemized deduction by the Browns? Conclusion That portion of the mortgage proceeds applied to the dental clinic generates an interest deduction to be claimed against clinic income on Schedule C. No other deduction is allowed Authorities IRC Section 265(a)(2) Rev.Proc. 72-18, 1972-1 C.B. 740 Wisconsin Cheeseman v. U.S., 388 F. 2d 420 Bradford, 60 T.C. 253 sraelson v. U.S., 367 F. Supp. 1104 Mariorenzi v. Comm., 490 F.2d 92, TC Memo 1973-141 PLR 8631006 Analysis and Summary The IRC disallows the deduction of interest on indebtedness that is incurred or continued to purchase or carry obligations, the interest on which is exempt from the federal income tax. IRC 265(a)(2). This provision denies the double benefit that would be enjoyed by the taxpayer who would receive tax-exempt income while simultaneously claiming an investment- interest deduction for the interest expense paid, for example, by incurring a bank loan and using the proceeds to purchase municipal bonds The IRS examines evidence to infer the intent of the taxpayer who is incurring the indebtedness. Under Rev. Proc. 72-18, 1972-1 C.B. 740, a taxpayer who purchases exempt bonds can claim an interest deduction if the debt in question has been incurred (1) for personal reasons (e.g., via a mortgage to finance the purchase of residential property), or (2) for valid business reasons, as long as the borrowing does not exceed legitimate business needs Several court decisions have emphasized that the existence of such business motives must be documented clearly, as to both presence and amount. Wisconsin Cheeseman v. U.S., 388 F.2d 420 (CA-7, 1968); Bradford, 60 T.C. 253 (1973); on v. U.S., 367 F. Supp. 1104 (D. Md. 1973). Is Mortgage indebtedness is a classic illustration of an investment that will generate deductible interest expenses for the tax- payer who holds exempt bonds. However, the timing of such a mortgage transaction must be monitored to exhibit the proper motives for the benefit of the IRS. In one case, the taxpayer paid for his home with cash. Only later was an invest- ment program (that included municipal bonds) initiated and a residential mortgage secured. The IRS inferred that the mort- gage proceeds were in indirect support of the exempt indebtedness, and the deduction for the mortgage interest was disallowed. Mariorenzi v. Comm., 490 F.2d 92 (CA-8, 1974), T.C. Memo 1973-141. Had the taxpayer secured a mortgage before the home was completed, purchasing the exempt bonds out of savings, it appears that the deduction could have been preserved. The IRS has applied this doctrine outside of the Eighth Circuit, in PLR 8631006 Because the Browns live in the Eighth Circuit, the Mariorenzi doctrine prevails, and no itemized deduction is allowed at all, that is, for that portion of the loan that is applied to the school bonds. Rev. Proc. 72-18 is insensitive to portfolio- diversification motives, and no personal motive appears to exist that supports any other possible deduction. According to the logic of these precedents, the Browns should have sold the exempt bonds and then used the proceeds to finance their portfolio acquisitions. Actions to Be Taken Prepare letter, review results with client Suggest changes in portfolio holdings to regain the deduction. Preparer: Mary H. Polzin Reviewer: Char E. Mano