In a U.S. Tax Court case, Sherman Derell Smith v. Commissioner, T.C. Memo. 2025-24, dated March 24, 2025, Sherman Derell Smith disputed the IRS’s denial of a depreciation deduction for a rental property on his 2018 federal income tax return. The court ruled against the taxpayer, citing his failure to establish a proper depreciable basis under IRC §167 and Treas. Reg. §1.167(g)-1.

Key Issues and Findings

1. Depreciable Basis for Converted Property
   • The taxpayer converted a Los Angeles residential property to rental use in 2017.
   • Under tax rules, when personal use property is converted to rental use, the depreciable basis must be the lesser of:
     • Fair market value (FMV) at the time of conversion, or
     • Adjusted basis (original cost plus improvements, minus depreciation).
   • Smith did not provide evidence of the original cost or improvements of the property, making it impossible to determine an adjusted basis.
2. Lack of Reliable Fair Market Value Evidence
   • Smith attempted to estimate FMV at the time of conversion using real estate valuation tools from 2024, seven years later.
   • The court found this estimate unreliable, labeling it a “guestimate” that did not meet the precision required for depreciation calculations.
3. Late Filing and Procedural Issues
   • Smith’s 2018 tax return was filed in 2024, long after the IRS had issued a Notice of Deficiency in 2021.
   • The IRS and Smith resolved other tax issues in the case, leaving only the disputed depreciation deduction for consideration.

Court’s Conclusion

The Tax Court ruled that Smith was not entitled to the depreciation deduction because he:

1. Failed to substantiate the property’s depreciable basis, and
2. Did not provide a valid FMV estimate at the time of conversion.

As a result, the court disallowed the depreciation deduction in full, ruling in favor of the IRS.

Key Takeaway

This case highlights the importance of proper record-keeping when converting personal property to rental use. Taxpayers must provide clear documentation of both original cost and FMV at conversion to support depreciation claims. Using outdated valuation methods or incomplete records can lead to denied deductions and potential IRS scrutiny.

Taxpayers may accelerate the depreciation of their rental properties by conducting a cost segregation study. ICS can assist with an engineered cost segregation study. Our Cost Segregation studies are certified and managed by a team of ASCSP Certified Cost Segregation Professionals, and our cost segregation reports are consistent with the IRS Audit Techniques Guide and the standards of the American Institute of Cost Segregation Professionals (ASCSP).
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