Is Bad Work Deductible?

I came across an interesting Tax Court case recently that I thought I’d share with you. The gist of this case boils down to answering the question: Can you take a deduction for home repairs that are so poorly done they constitute the theft by the contractor?

This case involved a couple in New Mexico who contracted with an individual back in the mid 90s to build them a home. Shortly after the house was completed and the couple moved in, they began to notice problems - problems that quickly escalated to become major issues. The contractor came back with his team and performed several repairs, but things just kept getting worse.

Eventually the couple got fed up and sued the contractor for negligence, negligent misrepresentation, fraud, unfair trade practices, breach of warranty, breach of duty of good faith and fair dealing, and breach of contract. The case was eventually settled, and the contractor agreed to pay the couple a total of $130,000. The terms of the settlement said that the parties would release each other, and no-one would have to admit any fault, blame or any responsibility (pretty standard terms in the legal world).

Once the litigation was over the couple amended their tax refund and took a theft loss deduction that eliminated their entire taxable income and gave them a refund. They said that the work done was so bad it constituted fraud. The IRS didn’t bite, and after auditing the couple, issued a notice of deficiency. The taxpayers fought back and the case wound up in Tax Court.

At the hearing, the Court learned that the home had been inspected and a proper occupancy permit had been issued by the county. It also learned that the contractor had never been charged with any sort of criminal offense in connection with the home construction. The couple argued that under New Mexico law, a criminal conviction wasn’t necessary to demonstrate a theft loss due to fraud. It is sufficient to show that one party intentionally misled another with the specific intent to cheat or deceive that party.

In their decision the Court found that the couple hadn’t proven the contractor had specifically intended to cheat them when he took their money and built them a substandard house. He did build the house, after all, and came back to do repairs in the early days. At the most, the contractor was guilty of negligence, or breach of contract (failure to provide the quality construction he had promised). The couple were the victims of lousy workmanship, but without clear proof that it was deliberate, no crime had been committed … and therefore there was no theft loss to deduct.