1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 5901 GREEN VALLEY CIRCLE 3 CULVER CITY, CALIFORNIA 4 5 6 7 8 REPORTER'S TRANSCRIPT 9 NOVEMBER 17, 2015 10 CORPORATE FRANCHISE AND PERSONAL INCOME TAX HEARING 11 APPEAL OF 12 ROBERT H. LOWE and SHERYL L. BERKOFF 13 NO. 571973 14 AGAINST PROPOSED ASSESSMENT OF 15 ADDITIONAL INCOME TAX 16 17 18 19 20 21 22 23 24 25 Reported by: Kathleen Skidgel 26 CSR No. 9039 27 Juli Price Jackson 28 CSR No. 5214 1 1 P R E S E N T 2 For the Board Jerome E. Horton of Equalization: Chairman 3 Sen. George Runner (Ret.) 4 Vice Chair 5 Fiona Ma, CPA Member 6 Diane L. Harkey 7 Member 8 Yvette Stowers Appearing for Betty T. 9 Yee, State Controller (per Government Code 10 Section 7.9) 11 Joann Richmond Chief 12 Board Proceedings Division 13 For Board of Equalization Staff: Lou Ambrose 14 Tax Counsel IV Legal Department 15 Anthony Epolite 16 Tax Counsel IV Legal Department 17 For Franchise Tax Board: Sonia Woodruff 18 Tax Counsel 19 Ron Hofsdal Tax Counsel 20 For Appellants: Mark Bernsley 21 Attorney 22 Robert H. Lowe Taxpayer 23 Sheryl Berkoff-Lowe 24 Taxpayer 25 Carl Williams Witness 26 Matt McAllister 27 Witness 28 ---oOo--- 2 1 5901 GREEN VALLEY CIRCLE 2 CULVER CITY, CALIFORNIA 3 NOVEMBER 17, 2015 4 ---oOo--- 5 MR. HORTON: Ms. Richmond, what is our next 6 matter? 7 MS. RICHMOND: Our next matter is Item B, 8 Corporate Franchise and Personal Income Tax Appeals 9 Hearings. Item B1 Robert H. Lowe and Sheryl L. 10 Berkoff. 11 Please come forward. 12 Board Proceedings has received contribution 13 disclosure forms for today's hearings from the 14 parties, participants and agents. All forms were 15 properly completed and signed. All parties, 16 participants and agents are on the alpha listings 17 provided to your office. 18 Each person sitting at the table will be 19 asked to introduce themselves and, if necessary, 20 their affiliation with the taxpayer for the record. 21 Ten minutes is allocated for the taxpayer's opening 22 presentation, followed by ten minutes for the 23 Franchise Tax Board or Department's presentation, 24 and five minutes is allocated to the taxpayer for 25 rebuttal. 26 Mr. Chairman, this taxpayer was granted 30 27 minutes for their opening presentation and 15 28 minutes for their rebuttal. 3 1 MR. HORTON: Let me just reiterate, but 2 first I'm going to have staff introduce the -- the 3 issue, please. 4 MR. AMBROSE: Good morning, Mr. Chair -- 5 MR. HORTON: Good morning. 6 MR. AMBROSE: -- Members of the Board. 7 This is the matter of the appeal of Robert H. Lowe 8 and Sheryl L. Berkoff. 9 The issues before the Board today are 10 whether Appellants have shown that Respondent 11 Franchise Tax Board erred in its determination of 12 the basis of real property sold by Appellants and 13 the resulting taxable gain; and issue two is whether 14 Appellants have established reasonable cause for 15 abatement of the penalty for the failure to furnish 16 information. 17 MR. HORTON: Welcome to the Board of 18 Equalization. Members, pursuant to the request of 19 the parties, let me reiterate just to make sure that 20 it's clear. Each side will have -- has been granted 21 30 minutes to make their presentation considering 22 the complexity of the issue before us. The 23 Appellant has indicated that it would not take them 24 30 minutes, possibly 15, but you're certainly 25 welcome to it. 26 And we will grant the Appellant 15 minutes 27 on rebuttal. We're all good? 28 Ms. Richmond? 4 1 Okay. Well, welcome to the Board of 2 Equalization. Please commence with your 3 introduction for the record. Please be advised that 4 you have 15 minutes on rebuttal, and we will return 5 to you after the Department has made their 6 presentation. 7 MR. BERNSLEY: Thank you, Mr. Chairman, 8 Members of the Board. My name is Mark Bernsley. 9 I'm counsel for the taxpayers Rob Lowe and Sheryl 10 Berkoff, also known as Sheryl Lowe. 11 The Lowes are seated to my right. Carl 12 Williams, one of the experts, is to my left. Also 13 present in the audience, because we weren't allowed 14 enough seats up here, is Matt McAllister, another of 15 the experts in this case. 16 For the record, I would like to reserve 17 any time not used during my opening presentation to 18 add to my rebuttal time. 19 Before I begin my part of the presentation, 20 Rob would like to address your Board. So I'll let 21 him do that now. 22 MR. LOWE: Good morning. First of all, let 23 me say how appreciative I am to have the opportunity 24 to be before you. 25 I'm aware California is the -- I think the 26 only state in America that has a Board like yours. 27 You are the protectors of the taxpayer, to review 28 these matters. So I'm very fortunate to appear 5 1 before you. 2 Chairman Horton, I look forward to 3 communicating the fair and good work that you do 4 here. 5 MR. HORTON: Thank you. 6 MR. LOWE: As I said briefly before we were 7 sent back last time, I love California. I came here 8 as a -- as a little boy and this state has given me 9 everything. I've been paying my taxes here since I 10 was 15 years old and I take that responsibility very 11 seriously. I believe it's a privilege to live here 12 and I'm happy to pay my fair share to do so. But I 13 also believe in the principles of fairness and 14 common sense. 15 In the matter before you today, I happily 16 paid my full share of taxes and I paid them on time. 17 I paid millions of dollars in taxes on this 18 transaction before us today. I paid everything I 19 owed, which is why the IRS has never had any problem 20 with the exact same set of numbers that are being 21 questioned by the Board today. 22 Unfortunately, we don't have all of the 23 documentation going back 20 years. The State 24 Franchise Tax Board has demanded to see these, and I 25 apologize for that. I, uh -- I rely on my financial 26 advisors for those things. They had a computer 27 crash and there's some other extenuating 28 circumstances that I knew nothing about until long 6 1 after the fact. 2 But let me be clear, we spent every penny 3 we said we spent. And we will show you and have 4 shown you independent evidence to support this. 5 Because, with respect, it is absolutely impossible 6 to build a 10,000-square-foot, four-acre trophy 7 property in the most prestigious location on the 8 planet, one that broke sales records when it was 9 sold, for anywhere near the amount the State 10 Franchise Tax Board would have you believe. It 11 simply couldn't happen, and I'm fairly sure that you 12 understand that. 13 My family and I are only asking that common 14 sense be applied to this situation. We take this 15 very seriously. We're not trying to avoid our 16 responsibilities. If we were, we could have just 17 said, "Oops, sorry about that mistake," and paid it. 18 But we want to do what's right. And we want what's 19 fair. 20 We've provided numerous evidence that 21 substantiates the validity of this return and, 22 respectfully, I am not a liar. So we ask for you to 23 accept our return as filed. 24 Thank you very much. 25 MR. BERNSLEY: So, as you know, and as Rob 26 said, the issue is the amount of gain realized by 27 Rob and Sheryl -- excuse me -- Sheryl on their 2005 28 tax return. This was on the sale of their residence 7 1 in Montecito which was constructed and improved over 2 several years. I'm going to refer to the property 3 as Garden Lane, after the street that it was on. 4 The Lowes reported a gain of more than 5 $10 million and paid tax on more than $9.6 million 6 after the allowed exclusion. That's not what you'd 7 see if someone were looking to evade their taxes. 8 As you know, and as Rob mentioned, the case 9 is before you because the professionals, CPAs and 10 business managers, retained by the Lowes lost a 11 number of records and documents. But as you 12 understand, under Cohan versus Commissioner, known 13 as the Cohan Rule, the Board is empowered to 14 determine the basis based on the entire record and 15 you may conclude, and we ask that you conclude, that 16 the amount used on the tax return represents that 17 best, most reasonable estimate of that basis. 18 Now to even begin to understand this case, 19 you have to understand Garden Lane. It wasn't just 20 another house. The property on which it was built 21 was purchased in 1997 for $2.8 million. And I'm 22 going to use round numbers throughout my talk. 23 Garden Lane was the embodiment of Sheryl's 24 vision, and it was just as much an artistic 25 expression as it was a construction project. A 26 selection of color photographs from the record is 27 set forth in the hearing exhibit binder under 28 Exhibit 1 and also in the supplemental binder that 8 1 you have. All of those photographs are from the 2 record. 3 If you look at Exhibit 1, you'll see some 4 photographs that also have drawings on them next 5 to -- adjacent to a photograph of the property, 6 whatever part of the property that is. And what 7 that shows will -- is -- is that every door, every 8 accent, every finish was custom designed. This 9 wasn't an off-the-shelf property. 10 The best materials one could find were 11 used; many sought out for their hypoallergenic 12 properties because of allergies of the children. 13 Amenities included top-of-the-line appliances, 14 antique baccarat lighting, stone reclaimed from 15 streets in England and France requiring special 16 processes and artisans to install. 17 The structures were set in a meticulously 18 designed landscape of lawns, mature trees, orchards, 19 streams, ponds and lushly surrounded pathways, all 20 carefully designed and choreographed for their 21 unique contribution to an overall effect. 22 I understand that the Lowes were also 23 required to pay for repaving the public street in 24 order to get their permits. 25 As a testament to how special this property 26 was, it was featured in Architectural Digest as the 27 cover home, California Homes, Veranda, Santa Barbara 28 Magazine, and on Oprah Winfrey's television show. 9 1 Again, this was not just another house. But that 2 wasn't the end. 3 The home was in a continual state of 4 improvement and modification well into 2003. 5 Antique French paver decking was modified around the 6 pool, an Amdega conservatory imported from England 7 was purchased and installed, and other modifications 8 were done as well. 9 Keep in mind that the home was so 10 impressive that it came to the attention of the 11 buyer, a multi-billionaire, when it wasn't even on 12 the market. Now this was a buyer who could buy any 13 property he wanted and he could walk away from any 14 deal that he didn't like. So he didn't have to buy 15 this. 16 This was a discerning buyer and this guy 17 didn't just plunk down $25 million sight-unseen. 18 The transaction was contingent on a series of 19 inspections, to make sure that this property lived 20 up to his expectations. And obviously it did 21 because the sale closed. 22 And I invite you in Q and A to ask Sheryl 23 more about this property and how it came to be 24 because there are so many features and stories worth 25 note, including a treehouse that ended up costing 26 more than $10,000 in order to meet requirements to 27 protect the tree. It's -- it's unbelievable. We 28 can hardly scratch the surface here. 10 1 Now during this entire time, the Lowes 2 employed a business manager/CPA who was keeping 3 track of all of their financial dealings, including 4 the Garden Lane construction and the numerous bank 5 accounts that were used. 6 Between the time of the Garden Lane sale 7 and the time of preparing their 2005 income tax 8 return, Rob and Sheryl changed business managers. 9 Then later during the exam, as you heard, it was 10 revealed that the Szabo firm, the first CPA/manager, 11 suffered a computer crash and information and other 12 supporting documents were lost. 13 What is important here is that there was 14 nothing the Lowes did to cause the loss of records 15 or reasonably could have done to prevent it. It was 16 perfectly reasonable to hire CPA/business managers 17 to help them with their financial affairs and keep 18 track of their documents as the Lowes did, and 19 there's absolutely nothing wrong. In fact, in 20 today's world it's almost a necessity for many 21 people to have someone to prepare their tax returns. 22 Now, as a result of the absence of records, 23 the examination was initially set with delays in 24 providing requested -- excuse me, substantiation, as 25 the managers were trying to find it. 26 That result -- resulted in the assertion of 27 a penalty for failure to provide information. That 28 was legally inappropriate and unfair. And some of 11 1 the reasons why are: The examiner failed to heed 2 the FTB's own regulations by immediately sending an 3 IDR with the audit notice; he set unreasonably short 4 deadlines instead of working with the Lowes' 5 representative to find a timeline that would work; 6 there was no failure or refusal to furnish available 7 information, so the statute didn't even technically 8 apply on its face -- excuse me -- and Rob and Sheryl 9 and their accountant were not uncooperative 10 taxpayers here. This is not the kind of situation 11 where the penalty is or should be applied. 12 The appeal, as you know, began in May 2011, 13 four-and-a-half years ago. And as Rob said, what 14 we're asking your Board to do here today, after 15 four-and-a-half years of wrangling with the FTB, is 16 to recognize that it's more likely than not that the 17 Lowes spent what they claim they did to construct 18 and improve Garden Lane and to accept their 2005 19 return as filed. 20 Now other elements of the gain, such as the 21 actual sales price and expenses, are no longer 22 disputed by the FTB. 23 So let me talk about the evidence other 24 than Garden Lane itself and why you should make the 25 finding we request. I want to start by talking very 26 briefly about the financial records. Like you, and 27 I'm sure your staffs, when I started in this case 28 the first thing I did is went and looked at the 12 1 financial records to see what the story was that 2 they told. And the story was neither clear nor 3 complete from those financial records. So I 4 immediately sought records from the banks. But by 5 then it was already too late. 6 In hearing Exhibit 4, which is in your 7 book, you'll see what I was able to put together 8 about the financial records, including what we know 9 and can't know about the costs and the flow of funds 10 based on those available documents. But the 11 available financial documents don't address all of 12 the costs of Garden Lane. 13 Exhibits 4 and 5 show that the financial 14 documentation we can add up does not and can't 15 possibly be thought to cover all the costs. But 16 there are also two additional declarations that bear 17 on this point. 18 Sheryl provided a detailed declaration that 19 listed a number of features and projects done to 20 Garden Lane, and for many of those she had a 21 recollection of specific amounts that were involved. 22 But much, if not all, of what she testified to is 23 not reflected in the receipts and check registers. 24 As an example, the only part of the Amdega 25 conservatory that's represented in receipts is, I 26 think, a part of the installation and maybe 27 something having to do with the blinds. But most of 28 the costs just aren't there. 13 1 In addition, we only recently learned that 2 Kyle Irwin, whose declaration is at Exhibit 10 in 3 your booklet, provided design services for Garden 4 Lane. Yet there's absolutely no inkling of that 5 fact in any of the records that we had prior to 6 dealing with Matt and having to go out and find Mr. 7 Irwin to fill in some blanks. 8 So how many suppliers like Kyle Irwin are 9 out there that we don't even know about? We -- we 10 don't know. And, ultimately, we can't extrapolate 11 from the financial documentation because we don't 12 know how much of the project was actually completed 13 that corresponds with the documents that we do have. 14 If you don't understand that, I can go over it in 15 Q -- Q and A. 16 Interestingly, when the FTB finally 17 submitted their own analysis of the financial 18 documents on August 17th as a result of a Board 19 Member inquiry -- and this is four years into the 20 audit -- it became apparent that the difference 21 between what the FTB saw and what we saw from the 22 exact same documents was only $1.1 million 23 difference. That accounts for the $7.1 million that 24 the FTB is stuck on as opposed to the 8.2 that 25 you'll see in Exhibit 4 which was what I 26 characterize as the absolute minimum. 27 So if the FTB and the taxpayers are only a 28 million dollars apart on what the financial 14 1 documents show, what's been going on for 2 four-and-a-half years? The answer is that this case 3 isn't about what the financial documents show. What 4 this case is about, and what Cohan is about, is what 5 the financial documents don't show. The FTB stopped 6 where the financial documents end, precisely where 7 Cohan begins. The FTB ignored Sheryl's testimony; 8 her declarations aren't mentioned at all in their 9 August 17th memo. And the FTB claimed that 10 Mr. Irwin's declaration didn't matter either. 11 This case is, and always has been, about 12 the gap between the incomplete financial 13 documentation on the one hand and the 14 $13-and-a-half million claimed on the return on the 15 other. It's about how your Board should use the 16 Cohan Rule to do what's right and fair and just, 17 which I know you want to do. 18 Now, you don't need to reinvent the wheel 19 here. If the tax return amount can indeed be shown 20 to represent the best estimate under Cohan, there's 21 no need to start all over and go through the weeds 22 and, again, reinvent the wheel. 23 So if we can't determine the total costs 24 directly with the receipts and checks, we have to 25 look qualitatively at other indirect evidence. So 26 let me go the in -- go through the indirect evidence 27 that confirms the propriety of the original tax 28 return basis and gain. 15 1 HE-2, Hearing Exhibit 2 in your packet, is 2 a gain computation done cooperatively by the two 3 business managers during the Lowes' transition from 4 one to the other that was used to prepare the 5 return. It shows two components of basis: 6 $12.9 million roughly, almost 13, attributable to 7 the first manager; and an additional $535,000 that 8 was added by the second. 9 That computation ties exactly to the 10 $13-and-a-half million basis shown on the federal 11 return schedule shown in HE-3. Based on a roughly 12 $3 million acquisition cost, it applies cost of 13 construction, improvements and other basis 14 additions, if there were any, of approximately 15 $10-and-a-half million. 16 Of all the various schedules and 17 computations in the record, reason and logic tells 18 us that this one is the most accurate. Here's why: 19 First, the computation was the earliest one 20 we have, and it therefore was the closest one in 21 time and the most likely to be done by persons or 22 people most knowledgeable about the events and the 23 information that was available. 24 Second, the analysis was done at a time 25 when no one was under any pressure to make the 26 number anything other than what the available 27 information suggested it should be. 28 Third, there was no apparent concern at the 16 1 time about its accuracy or supportability. So even 2 though we don't know now exactly how it was derived, 3 there's no indication in the record or in any 4 documents that they were concerned about its 5 supportability. 6 Fourth, the preparers were professionals 7 with obligations imposed by state licensing laws, 8 ethical obligations, and IRS rules to prepare and 9 sign only proper and accurate returns and because 10 they had a fiduciary responsibility to the Lowes in 11 advising them that they could honestly sign this 12 return under penalty of perjury. 13 Now I know that by itself doesn't carry 14 today because that's true of all returns. But we 15 can't go around assuming that all tax returns are 16 false. So we can come back to that item, but I 17 think it is significant. 18 Fifth, there was no motivation for anybody 19 to lie or embellish here. If you think about it, 20 the first manager was losing a client; the Lowes 21 were out the door. There was nobody for them to 22 impress here. And the second manager could, and 23 indeed had to, rely on the first for the number. So 24 he wasn't really taking responsibility for the 25 number, other than the $535,000. And let's face it, 26 the computation itself may well have been done by a 27 junior accountant who couldn't have cared less what 28 the number was. 17 1 So there was no incentive here for anybody 2 to stick their neck out for any number that they 3 didn't think was solid. 4 But there's more. 5 The Lowes have now offered two detailed 6 expert opinions: 7 One, from Mr. Williams, on my left, who as 8 a construction loan disbursing agent had acquired 9 extensive knowledge of Montecito construction costs, 10 and who also served as a disbursing agent on the 11 construction loan on Garden Lane. So he had direct 12 knowledge of this specific property. 13 The second opinion was from Matt McAllister 14 who's also here, sitting behind me. He's a 15 sought-after contractor in the Montecito market who 16 provided his opinion of the current cost to build 17 Garden Lane, and from which a total cost could be 18 inferred and then discounted back to the current -- 19 to the appropriate time frame. And those 20 declarations are in HE-6 through 9. 21 By the way, the discount factor that I 22 used, that's shown in HE-11, was not as the FTB 23 argued, a broad-based CPI, but was specific to 24 housing costs. If you look closely at HE-11 in the 25 descriptive title the numbers are the U.S. city 26 average housing cost numbers. 27 What's important here, though, is not the 28 precise number of these experts' conclusions, but 18 1 that both of them are familiar with the market and 2 the type of construction that Garden Lane 3 represented. And both of their conclusions are 4 entirely -- entirely consistent with the Lowes' 5 basis being what they claimed it was. 6 But there's more. 7 The FTB and your Board frequently turn to 8 assessor records to determine basis. Essentially 9 that analysis assumes that the assessed value of 10 improvements at or near the time of construction 11 will approximate construction costs. Now actually, 12 the assessments are often less than actual 13 construction costs and that's borne out by Kasey 14 Kump who provided a declaration also. So it's a 15 very conservative approach that generally favors the 16 FTB, but it's ballpark. 17 And we know that Garden Lane wasn't 18 assessed correctly at the time of construction, but 19 the property was reassessed immediately after sale 20 before anything was done to it. So we do have an 21 assessor value of those improvements based on how 22 the property was sold at a subsequent time frame. 23 So in HE-12 shows an analysis where that 24 later assessed value was discounted back to the 25 appropriate time frame. And that, too, supports 26 that the Lowes' basis as claimed is consistent with 27 what the assessor thought the value should be. 28 Again, it supports the legitimacy -- oh, 19 1 what I was going to say, in HE-13 and 14 I have two 2 additional properties, sold at about the same time, 3 where I use the exact same method. And what that 4 shows is that this methodology does not skew towards 5 the improvements. And so that underscores the 6 legitimacy in concern of the nature of the approach. 7 But there's still more. 8 As Rob mentioned, the IRS accepted the 9 Lowes' basis and gain as filed. Now that by itself 10 may not be significant, but the reason for that, I 11 think, is. IRS statistics, which are shown in 12 HE-16, show that the basis claimed by the Lowes as a 13 percentage of the sales price is entirely consistent 14 with what the IRS expects and sees on an average 15 basis across the country. 16 In fact, the Lowes' basis was a little 17 lower, showing that they reported more gain than the 18 IRS normally sees in these kinds of sales. 19 There's yet more. 20 The opinion of Kasey Kump, an appraiser for 21 the county tax assessor, with no ties to this case, 22 estimated the current construction cost today for 23 Garden Lane would be close to $1500 a foot. Again, 24 this is in line with the expert opinions and the 25 basis as claimed on the Lowes' return. 26 And there's yet another point. The Garden 27 Lane sale is shown in HE-17 in the context of 28 contemporary sales under the MLS for the area. 20 1 There's a map showing the properties, and the 2 location of Garden Lane is shown in red. The only 3 property that came anywhere near, drawing anywhere 4 near the price of Garden Lane was a two-parcel lot 5 on the beach, and most of the value of that property 6 was assigned to the land. 7 What most of this evidence has in common is 8 the needed perspective and familiarity with the 9 nature of the construction, of the quality of Garden 10 Lane and the Montecito market. 11 As Rob said, we wish we could have provided 12 a hundred percent of the records. This case would 13 have long ago been over. We couldn't. We've given 14 you a chorus of the next best thing. And that 15 chorus sings in harmony that the actual costs of 16 Garden Lane are consistent with the basis they 17 claimed on their return. 18 The application of Cohan is not a precise 19 science. Cohan concerns itself with the general 20 size and shape of a forest, rather than an account 21 of the trees. And we're talking about costs that 22 were incurred some 15 years ago. It's next to 23 impossible to estimate such costs with precision. 24 And there's never any certainty in a Cohan 25 case. But if one looks at this case qualitatively, 26 there are numerous pieces of evidence, all showing 27 that it is clearly more likely than not that the 28 basis claimed by the Lowes on their return was 21 1 truthful and accurate. We ask your Board to make 2 such a determination. 3 The administration of our taxes essentially 4 comes down to trust. In our self-assessment system, 5 taxpayers file returns swearing under penalty of 6 perjury that their returns are correct; preparers 7 make a similar certification. Rob and Sheryl and 8 their accountants did that here. 9 Our system trusts that most returns are 10 indeed reasonably accurate and accepts them as 11 filed. But to ensure that integrity, we have audits 12 that promote compliance by looking to discover 13 people that have either intentionally filed 14 dishonest returns -- in other words, cheated -- or 15 made material mistakes, whether honestly or 16 negligently. 17 The difference between the FTB position and 18 the Lowes' return here is too large for a mistake or 19 it would have long ago become obvious and we could 20 have addressed it. 21 No one has suggested that the Lowes' return 22 here was intentionally wrong, but that's the 23 implication of the FTB position and why the Lowes 24 have fought so hard throughout this four-plus-year 25 battle. 26 If there's no mistake and there's no 27 intentional cheating, the only explanation left is 28 what Rob and Sheryl have been saying all along, that 22 1 they filed an accurate return but that, 2 unfortunately, through no fault of their own, the 3 evidence that would prove that unequivocally is now 4 gone. 5 In summary, everyone with demonstrable 6 knowledge of the Montecito construction cost market, 7 and independent government records, statistics and 8 county employees familiar with Montecito 9 construction costs, all confirm that what they would 10 expect as the cost of Garden Lane is entirely 11 consistent with what Rob and Sheryl used as their 12 basis for computing gain. 13 I ask that you also see that and see that 14 Rob and Sheryl's claimed basis is reasonable under 15 Cohan. Be fair to these taxpayers. Tell them what 16 they have waited four-and-a-half years and deserve 17 to hear, that you know they haven't lied, and please 18 accept their return as filed. 19 Mr. Chairman. 20 MR. HORTON: Thank you. 21 Members, we'll now go to the Department. 22 The Department has ten minutes to make -- strike 23 that. 24 The Department has 30 minutes to make their 25 presentation. Please be advised we will return and 26 allow you 15 minutes on rebuttal. 27 MS. WOODRUFF: Okay. 28 Good morning and thank you, Mr. Chairman 23 1 Horton and Members of the Board. My name is Sonia 2 Woodruff, and with me today is Ron Hofsdal. We 3 represent the Franchise Tax Board on this matter. 4 Also with us today is our expert witness Kory 5 Kruckenberg; he's here to answer any questions that 6 you might have of him. 7 We would not be here today if Appellants 8 had spent the $10.6 million that they claimed to 9 have spent and they had the documents to support 10 that amount. The difference between the basis that 11 Appellants claim and the, uh -- and the basis 12 that -- that Respondent has allowed is over 13 $6 million. 14 Appellants allege that this $6 million 15 exchanged hands without leaving a trace of those 16 transactions. Now, while unfortunate events such as 17 lost records do happen, the fact is that actually 18 quite a lot of evidence has surfaced in this appeal 19 and there appears to be almost a complete record. 20 Virtually none of that evidence supports Appellants' 21 claims of spending over $10 million to renovate 22 their home. 23 So this case is not about whether 24 Appellants built a beautiful high-end home because 25 nobody disputes that. The question here is how much 26 they may claim as their basis, the amount that they 27 actually spent to renovate that property. And of 28 course the law requires that all taxpayers maintain 24 1 relevant records to support their -- their expenses. 2 And in this case Appellants have provided checks, 3 invoices, and check registers reflecting around 4 $4.2 million of expenses. Meanwhile, Respondent has 5 allowed slightly more than 4.2 million in 6 construction expenses, 2.85 million for the initial 7 purchase and additional expenses, for a total basis 8 on appeal of 7.18 million. 9 Now, this amount is actually more than the 10 records support, but it appears reasonable in light 11 of all the evidence that's surfaced in this case, 12 including homeowner's insurance records, appraisals, 13 property tax assessment records, and Appellants' own 14 accounting records. 15 After claiming during protest that they had 16 lost documents, on appeal Appellants were able to 17 provide thousands of pages of documents. And the 18 main problem with this evidence is that much of it 19 is duplicative. 20 For example, if I incur a hundred-dollar 21 expense, that expense could be reflected in many 22 different ways: There would be a cancelled check; a 23 check register showing that the check was written; 24 an invoice or receipt for the same expense; an 25 accounting report noting the expense; and I could go 26 out to that person who received the check and -- and 27 receive a signed statement stating that they 28 received a hundred dollars from me. 25 1 And if you added up all of those separate 2 items as separate proof of my expense, you might 3 think I spent 500, but in actuality I spent a 4 hundred dollars. 5 And that's the main problem that we've had 6 with Appellants' documentation. With the 7 substantial volume of documents provided on appeal, 8 it has been a significant task to review each and 9 every check, each and every invoice and line item in 10 a check register, but we've done so. And after 11 eliminating duplications, the record reflects 12 $4.2 million of expenses. 13 So prior to the last hearing, FTB was asked 14 to provide a chart of evidence considered in this 15 matter. And in so doing, we went through and found 16 items that we inadvertently had double counted and 17 also some items that should have been included but 18 weren't. Overall, however, the total amount that 19 should have been allowed was still less than the 20 construction costs already accepted by FTB. 21 There are five main points I'd like to 22 cover in today's presentation: The evolution of 23 this case; the problem with Carl Williams' report; 24 the problem with the attestations; the problem with 25 using sales price to prove basis; and the 26 substantial evidence that supports Respondent's 27 position. 28 FTB began its audit in July of 2007. And 26 1 after months of requesting information, Appellants 2 failed to supply any documents. Finally, after 15 3 months and several letters warning about the 4 possibility of a penalty, FTB issued an assessment 5 with a failure to furnish penalty. Because no 6 documents had been provided at that point, 7 Respondent based the assessment on public records 8 and mortgage loan documents. 9 During protest Appellants changed their 10 representative to their former accountant Mr. Szabo, 11 who is the person who originally maintained all of 12 Appellants' financial records. And he said that due 13 to a computer crash in May of 2002, he could not 14 locate source documents, but he was able to provide 15 a three-page accounting report of Appellants' 16 construction costs and a few other documents. 17 Now, throughout the protest Appellants' 18 position on their construction costs changed as Mr. 19 Szabo revised their claimed basis amount. They 20 initially represented they spent 8.4 million on 21 construction costs, but they also attempted to 22 capitalize over $2 million in mortgage and 23 construction interest. 24 And after apparently realizing that this 25 interest could not be added to basis, they revised 26 their figures several times, ranging from claimed 27 construction costs of 8.4 million all the way down 28 to 4.8 million. 27 1 None of these amounts, however, 2 supported -- were supported by Mr. Szabo's 3 accounting report, which included total construction 4 costs of 3.3 million. Mr. Szabo represented that 5 this report was the total accounting for the 6 construction performed on the Garden Lane property 7 from May 1997 through June of 1999. 8 And Respondent's protest hearing officer 9 used Mr. Szabo's accounting report to allow basis of 10 3.3 million. And she also allowed additional 11 invoices that Appellants were able to produce and 12 the initial purchase price, for a total basis at 13 protest of 6.7 million. 14 Now, this amount was extremely favorable to 15 Appellants in light of the documents that had been 16 provided by that point. FTB allowed basis of 3.3 17 million based solely on an accounting report with no 18 supporting documents in addition to some invoices. 19 And it now appears that that accounting report may 20 have come from the check registers that were 21 provided at appeal, dated May 1997 through June of 22 1999. 23 But on appeal Appellants have changed their 24 approach. They now rely on the opinion of Carl 25 Williams who they allege has special knowledge of 26 the construction costs. Mr. Williams originally 27 estimated that Appellants spent at least 9.9 million 28 to construct the Garden Lane property. Now, please 28 1 keep in mind that this amount is still over $600,000 2 shy of the position that they took on their tax 3 return, but they argue that this estimate is 4 essentially close enough. 5 Now, after appeals briefs were filed, the 6 Board staff pointed out to both parties that the 7 property tax assessment records reflected that 8 Appellants had reported construction work valued at 9 only 2.859 million as of December 1998. 10 And after closer review of that form and 11 the building permits, FTB questioned whether 12 Appellants had ever built a guest house above the 13 garage in 2002 or 2003 as claimed in Ms. Berkoff's 14 declaration. And after obtaining the building 15 department records for Garden Lane, it came to light 16 that in fact, while Appellants had applied for the 17 permit to construct the guest house, the work had 18 never actually been completed. 19 Furthermore, on review of those building 20 department records, it does not look like Appellants 21 added a master bathroom to the home in 2002 or 2003 22 as claimed in the declaration. A master bath 23 appears to have been part of the original plans and 24 construction of the home. Mr. Harding, the 25 appraiser who appraised the property at least four 26 times physically inspected the master bathroom, 27 along with the rest of the house, and described it 28 in his June of 1999 appraisal. 29 1 So, to date, Appellants have not really 2 responded to this question, but the master bath 3 addition appears to be another item of work that 4 was -- was not added to the home later on as 5 claimed. 6 So after acknowledging that the guest house 7 was not built as originally claimed, Mr. Williams 8 revised his original report. But the overall number 9 of basis only went down by about $200,000, bringing 10 his estimate of the cost of work to 9.7 million. 11 And this amount, again, is still over $800,000 shy 12 of Appellants' claimed construction costs. But, 13 again, Appellants argue that this is close enough. 14 Appellants argued that the Cohan Rule 15 should be allowed -- applied to increase basis even 16 over and above what their own expert is able to 17 estimate. 18 I'd like to focus on Mr. Williams' report. 19 His report is the only piece of evidence that really 20 gets Appellants close to their claimed construction 21 costs of 10.6 million, other than the newly 22 submitted McAllister estimate which is far too vague 23 to be of any evidentiary use. 24 Mr. Williams' estimate still falls far shy 25 of Appellants' total claimed construction costs, but 26 it's the only piece of evidence that gets them close 27 to that position. But the Williams report is 28 seriously flawed when you take a look -- closer look 30 1 at the figures. 2 The major flaw with the Williams report is 3 that it's not an estimate of the actual costs 4 incurred on Appellants' home. His report is a 5 theoretical estimate of what someone might spend to 6 build a home in Montecito based on a database that, 7 until very recently, we were not able to see. And 8 because Mr. Williams was not basing his estimate on 9 a -- specific expenses for this property, his 10 estimate amounts to a patchwork quilt of expenses 11 from different homes. So essentially Mr. Williams' 12 database could lead one to any desired amount of 13 costs. 14 At the last hearing date, Mr. Williams gave 15 us five samples from his database. And three of 16 those homes were built in 2011, one in 2007, and one 17 in 2004. So they were built long after the relevant 18 time period, as we know that Appellants' home was 19 substantially complete by 1999. 20 But even though the properties were built 21 much later than the Garden Lane property, they still 22 do not support the price per square foot claimed by 23 Appellants. Appellants claim a price per square 24 foot of approximately $900 -- actually more than 25 $900, while the average price per square foot of the 26 projects in Mr. Williams' database was about $600 or 27 $436 per square foot when you take into account the 28 appropriate discount factor. 31 1 Now, the sample properties call into 2 question Mr. Williams' entire method of estimating 3 costs because they simply don't support his 4 conclusions. 5 There are many other clear errors in the 6 Williams report. Aside from the guest house and the 7 master bath addition, the Williams report valued 8 concrete at $147,000. That amount is absurdly high 9 when we know that the main home's existing 10 foundation was used and only 300 square feet of 11 concrete was added along with a new foundation for 12 the pool house. According to Appellants' records, 13 they spent $39,000 on all foundation work, the main 14 house and the pool house. 15 Furthermore, Mr. Williams allocated over 16 $600,000 to framing the main home when we know that 17 the remodel retained a significant amount of framing 18 from the original house and Appellants' accounting 19 records reflect that they spent about $106,000 to 20 frame the main house. 21 Mr. Williams allocated nearly $500,000 to 22 framing the pool house when Appellants' records 23 indicate they spent about $19,000 for this aspect of 24 the construction. 25 Mr. Williams allocated $1.2 million to 26 rebuilds, changes and upgrades, when the only 27 claimed rebuild in the record was some repairs to 28 the pool house after a septic flood. 32 1 Mr. Williams estimated the contractors fee, 2 overhead and profit at nearly $1 million, and 3 another 325,000 for general supervision when the 4 general contractor Bruce Sweet only received about a 5 hundred thousand dollars as reflected in Appellants' 6 accounting report and check registers. 7 Another notable fact is that Mr. Williams 8 listed a little over $350,000 for architects fees, 9 who is Mr. Don Nulty. Now, Appellants, in their 10 most recent filing, argue that the Respondent cannot 11 rely on Mr. Nulty's attestation in which he claims 12 to have received $350,000 for his architect 13 services. But this point ignores the fact that 14 Mr. Williams also estimated the architects fees 15 about 350,000. And this is one amount that appears 16 appropriate because Appellants' contract with 17 Mr. Nulty is in the record, and that contract states 18 that Mr. Nulty is to be paid on both an hourly basis 19 and as a percentage fee of the total claimed 20 construction -- or total construction costs. 21 So when you take into account his hourly 22 services, which are clearly detailed in the invoices 23 provided at appeal, and you factor in Mr. Nulty's 24 seven percent fee of the total construction costs, 25 you can determine that the total cost for the 26 project was 3.39 million, or at least that was the 27 amount of construction costs that Mr. Nulty's fee 28 was based on. And that amount accords with the 33 1 accounting report. 2 So because we have Mr. Nulty's contract and 3 know that he was supposed to receive a fee of seven 4 percent of the construction costs, excluding certain 5 interior design items, we can see that if the total 6 costs were 9.8 million, as Mr. Williams claims, 7 Mr. Nulty should have received a fee of well over 8 $600,000. And that amount is significantly more 9 than the amount shown or Mr. Nulty's attestation and 10 in the Williams report. 11 So Mr. Nulty's fee is just one example of 12 many. All of the available evidence, other than the 13 Williams report, reflects construction costs of less 14 than half of what Appellants claim. 15 So I'd like to touch briefly on the 16 attestations because they've gotten a lot of 17 attention in this appeal. During the protest, 18 Appellants submitted several statements from various 19 people claiming to have received a total of 20 $2.6 million from Appellants' four construction 21 costs. And Respondent did not allow additional 22 amounts of basis for these attestations because the 23 overall problem we have with these statements is 24 that they are redundant. So that is most of the 25 costs were paid from the original construction loan 26 and Respondent has already allowed basis for those 27 amounts. 28 So allowing additional basis for the 34 1 attestations for the most part would be double 2 counting. For example, the records reflect overlap, 3 clear overlap of 1.3 million, and those are amounts 4 claimed in the attestations that you can see were 5 paid from the main construction accounts. FTB has 6 already accepted those amounts, and the details for 7 those amounts are in table B-1 which was -- was 8 provided prior to the last hearing. 9 And we believe that there's even more 10 overlap between the attestations and the already 11 allowed construction costs, but it's impossible to 12 prove because many of the attestations cover things 13 like supplies and materials and we know that those 14 items were also paid for through the construction 15 accounts. It's very difficult to match up amounts. 16 There are too many other problems with the 17 attestations to cover today, but the concerns that 18 we have with them are detailed in table B-1. And to 19 name just a few: It's unclear where the numbers 20 came from, the attestants or Mr. Szabo. And if the 21 numbers came from source documents, why weren't 22 those source documents provided? Many of the 23 attestations directly conflict with other items in 24 the record, especially Mr. Williams' report. 25 So the issue of sales price and what it 26 might indicate about basis has come up quite a bit 27 in this appeal. But sales price does not tell us 28 anything about basis, which is the cost of the 35 1 property in the hands of the taxpayer. Sales price 2 could be affected by so many different variables 3 that it's not really useful to extrapolate the cost 4 of a property from its sales price. 5 For example, if an exact replica of this 6 property was sold in a less desirable area, it would 7 have sold for much less. The value of the land, the 8 neighborhood, appreciation in the market, any number 9 of factors could have gone into the sales price of 10 Garden Lane. 11 What we do know is that a little over one 12 year before the sale, the property appraised for a 13 total of 13.5 million. Mr. Harding stated in one of 14 his appraisals that the quality and finishing of the 15 property was on par with the quality of other 16 Montecito homes. So, in other words, while it was a 17 beautiful and high-end home, for the area it was not 18 extraordinary. 19 The sales price of this home or comparable 20 homes does not help to ascertain the costs to 21 Appellants to construct Garden Lane. So if this 22 property sold for 150 -- $150,000 or $150 million, 23 the analysis as to basis would be exactly the same. 24 So rather than speculating on something as 25 variable as the sales price, let's look at the firm 26 evidence in this case. The documents Appellants 27 have provided on appeal are extremely detailed and 28 very telling. As mentioned earlier, they provided 36 1 two check registers, which appear to support the 2 accounting report provided at protest, and these 3 registers reflect expenses of 3.2 million occurring 4 between May of 1997 and June of '99, the period of 5 time when substantially all of the construction work 6 occurred. 7 They also provided very detailed invoices, 8 often with check stubs attached, for work performed 9 in the same time period and after. So if you look 10 at the costs detailed and those items together, you 11 can see that they cover substantially all of the 12 claimed work in Ms. Berkoff's declaration, with the 13 exception of the guest house and the master bath 14 addition. 15 So, from the documents provided by 16 Appellants, you can see that about 4.2 million was 17 spent on all the construction costs from 1997 18 through 2004, and we have a fairly complete record 19 of the work that was performed and how much it cost. 20 Appellants claim that they have lost 21 documents that would prove over $6 million of 22 expenses, but it's difficult to understand lost 23 documents of this magnitude when you review the 24 check registers, checks and invoices and see the 25 expenses that were covered by those documents. And 26 this point is important because Appellants want us 27 to apply the Cohan Rule, but the Cohan Rule only 28 tells us that if you incur an expense and can prove 37 1 that you did so but you cannot prove the exact 2 amount, it's appropriate to estimate a reasonable 3 amount -- reasonable amount for that expense. But 4 the documents provided cover so many of the claimed 5 expenses, so exactly which parts of the construction 6 do Appellants claim were not covered by the 7 missing -- by the existing documents? 8 While Cohan allows for estimation, it still 9 requires certainty of the missing work and some 10 basis on which to estimate a reasonable amount. For 11 example, if Appellants had said, "We built a pool, 12 but we have no documents to prove how much we 13 spent," but clearly looking at building permits and 14 photographs we can see that you built a pool and 15 generally the materials used, this would be a 16 perfect time to apply Cohan. 17 We could determine the average cost for a 18 pool of that caliber in the area and how much it 19 might cost at that time. And that's not what we 20 have here. 21 In this case, we see payments for the check 22 register for the pool, so we can't estimate based on 23 Cohan when we have the actual cost data from the 24 check registers. 25 So instead of specifying which expenses 26 have not been included in basis but should have 27 been, Appellants argue that they must have spent 28 this missing $6 million because Mr. Williams thinks 38 1 it's likely. They argue that the Cohan Rule should 2 be allowed or used to allow expenses based on their 3 expert's report, but even that report only gets them 4 to 9.78 million. 5 So after using Cohan to estimate cost 6 basis, Appellants want this Board to allow an 7 additional $869,000 just because it's close enough. 8 But this is not how the Cohan Rule is supposed to 9 work. Cohan is not a blank check. The Ninth 10 Circuit Court of Appeals tells us that Cohan does 11 not obviate the need for proof of entitlement to an 12 expense and that a trier of fact may not be 13 compelled to guess expenses based on Cohan. 14 In the appeal of Albert Aching, this Board 15 found that the Cohan Rule did not allow for mere 16 speculation, unsupported allegation, or inference. 17 Finally, Cohan does not allow us to ignore 18 the available evidence and allow extra amounts just 19 because taxpayers think that they spent much more. 20 Even though the records appear to be complete 21 regarding the work performed and their costs, 22 Respondent accepted Appellants' statement of lost 23 records. And in order to apply the Cohan Rule 24 properly on appeal, FTB looked to the available 25 contemporaneous evidence to try and find support for 26 that missing $6 million. 27 But the more we looked at that 28 contemporaneous evidence, the more support we found 39 1 for construction costs of around 4.2 million. Cohan 2 could not be used to allow any more expenses because 3 all of the available evidence confirmed the basis 4 already accepted was correct. 5 So let's take a look at some of that 6 evidence. 7 In 1999 Appellants insured their home for 8 $3.3 million. They adjusted this amount every two 9 years until 2003 when they insured it for 10 4.7 million. So it's unlikely that anyone would 11 spend $10.6 million on construction and then insure 12 their home for less than half of that amount. 13 And, in fact, the language of Appellants' 14 policy specifically required them to insure the 15 dwelling to its full replacement cost at the time 16 the policy was issued, with periodic increases for 17 inflation. 18 The property was appraised at least four 19 different times between 1998 and 2003. The 20 appraiser John Harding visited the property and 21 physically inspected it each time he appraised it. 22 His appraisals estimated the cost to reproduce an 23 exact replica of this property ranged from 24 2.6 million to 5.3 million. Now that reproduction 25 cost is for an entirely new home, built from 26 scratch, which we do not have here. 27 But Mr. Harding's appraisals were performed 28 close in time to the actual work. He walked the 40 1 property. He reviewed permits and spoke to 2 Appellants and the contractor about the work that 3 was done. He made detailed notes on the finishes, 4 the appliances, and the quality of the workmanship. 5 He relied on both his extensive experience in the 6 Montecito area and his knowledge of appraisal 7 methods to conclude that this exact property could 8 have been built from the ground up for less than 9 half of what Appellants claimed to have spent. 10 Mr. Harding's method of estimating 11 reproduction costs is an established method, defined 12 by standard appraisal methods and backed up by his 13 years of experience and his knowledge of local 14 workmen. 15 FTB's expert witness Kory Kruckenberg 16 reviewed the evidence and concluded that this 17 property could have been built for approximately 18 $4 million. Mr. Kruckenberg based his opinion on 19 Mr. Harding's 2003 appraisal, because at that time 20 that evidence was the most credible and reliable 21 piece of evidence in the record. We've subsequently 22 obtained additional appraisals performed closer in 23 time to the actual construction. 24 Mr. Szabo reported to the property tax 25 assessor that the total cost of construction was 26 2.859 million, as of December 15, 1998. And 27 Appellants claim that this statement was a mistake, 28 but if you look at the check registers as of that 41 1 date, 2.9 million was actually pretty accurate, 2 suggesting that the one person who had access to all 3 of Appellants' financial records believed the cost 4 of the project to be less than $3 million as of 5 December 1998. 6 There are also Mr. Williams' documents from 7 the time of the construction, reflecting hard cost 8 disbursements of approximately $2 million for 9 construction-related expenses. And finally, the 10 original contractor's estimate of costs came in at 11 about 1.75 million. 12 Now, Appellants have explained each one of 13 these items of evidence and explained everything in 14 the record that contradicts their claim of spending 15 10.6 million. They claim that they chose to only 16 partially insure the home. They claim that the 17 appraiser was wrong. They claim that the property 18 tax assessor information was a mistake. They claim 19 that they never said they built a gust house, but 20 that their attorney misunderstood them. 21 So there's an explanation for every piece 22 of evidence in the record. But when you step back 23 and look at the totality of the evidence regarding 24 this property, you see that all of the 25 contemporaneous evidence points in one direction, 26 and that's to construction costs of around 4.2 27 million. 28 I also want to note that they claim their 42 1 accountant's position on the tax return must be 2 given great deference, but we must somehow ignore 3 all of that same accountant's contradictory 4 positions during protest. And by the way, we must 5 also ignore his accounting records and his statement 6 on the property tax assessment form. 7 So the $6 million difference between what 8 Appellants can show that they spent and what they 9 claim to have spent is a substantial gap. It's not 10 close enough and it cannot be allowed based on 11 guesses and speculation. If it could be, there 12 would be no reason for the rule that taxpayers must 13 retain records to claim their expenses. There'd be 14 no incentive to retain actual records when you can 15 always just estimate them later with a little help 16 from an expert witness. 17 From a tax administration standpoint, FTB 18 cannot apply the Tax Code fairly for all taxpayers 19 if we allow unsubstantiated expenses of this 20 magnitude. 21 I also want to note that in light of all of 22 the evidence provided in this case, and especially, 23 you know, being able to see samples from 24 Mr. Williams' database, the FTB has determined to 25 withdraw the failure to furnish penalty. 26 And if this Board determines to make 27 additional estimates, the 2003 appraisal is really 28 the most appropriate place to start. Mr. Harding 43 1 physically inspected the property and arrived at his 2 estimated reproduction cost long before this tax 3 controversy. Without discounts and with additions 4 for landscaping, such an estimate would come to 5 about 8.8 million for total basis amount. And that 6 appears to be the best and highest estimate in the 7 record made closest in time to the actual work. 8 So that amount of basis appears to be 9 supported by the average price per square foot, as 10 noted in Mr. Williams' new -- or samples that he 11 was -- that he provided at the last hearing. 12 So I'm happy -- with that, I'm happy to 13 answer any questions. 14 Thank you. 15 ---oOo--- 16 17 18 19 20 21 22 23 24 25 26 27 28 44 1 ---oOo--- 2 MR. HORTON: Thank you very much. 3 On rebuttal, please. 4 MR. BERNSLEY: Thank you, Mr. Chairman. 5 I think the main problem with the FTB 6 position is -- 7 MS. HARKEY: Would you pull your microphone 8 closer? 9 MR. BERNSLEY: -- yeah. 10 The main problem with the FTB position is 11 that there is no credible set of facts into which it 12 fits. 13 If the real basis here was four or five 14 million dollars, how could $13 million get on the 15 return? How could that be? 16 How could the accountants have been so 17 confident that they had a good, supportable number 18 and been so far off? 19 Again we get back to, you know, life has to 20 make sense. There's a story here some place. 21 And -- and it's just -- it's hard for me to imagine 22 how these accountants and business managers, who had 23 been around so long and seen all of this as it went 24 by, whatever happened, how could they be that far 25 off? So, it doesn't make a lot of sense to me. 26 The comment regarding there being no trace 27 of records. There -- there were records. 28 And I think the evidence shows that records 45 1 were, indeed, being kept. And, unfortunately, there 2 are also a bunch of records that are missing. 3 The Exhibits 4 and 5, that I mentioned, 4 showed that we can trace the funds through certain 5 accounts. But clearly there are other bank accounts 6 where all we have are one or two checks. 7 And the FTB keeps referring to this as "a 8 fairly complete record." It's not. It's not a 9 fairly complete record. 10 We have a fairly complete set of two bank 11 accounts, knowing that there are three or four or 12 five other bank accounts where we only have bits and 13 pieces. 14 And there's no way to tie the records that 15 we do have into the construction project and see, 16 okay, this is how much got completed for that amount 17 of expenditure. There are too many gaps. 18 If you look at this on a line item basis, 19 there's -- you know, as Mr. Williams did and 20 Mr. McAllister did -- the difficulty is if you were 21 going to make -- you know, if you were a mission and 22 you knew exactly what happened and you were going to 23 make a spreadsheet showing the real costs and 24 compare that to -- to the expert opinions, you know, 25 if you have -- if you know that you've paid, you 26 know, $10,000 to a carpenter. You have a line item, 27 $10,000. 28 But you don't know from that whether he was 46 1 the only carpenter, whether that was the only 2 $10,000 he got, whether there was six other 3 carpenters and how many other line items. 4 So, when we see a line item on a 5 spreadsheet, there's no way to know what's missing 6 and how much of -- of the project was completed by 7 then. 8 We understand that with the attestations 9 and comparing those to the documents that there is 10 some overlap. 11 The schedule that I did with my very first 12 brief was very, very cautious in not double counting 13 any of those expenditures. So, yes, there was 14 overlap. 15 The -- the attestations were done during 16 the audit. I think you did them, right? 17 Rob did those himself and, so, there was no 18 order or scientific basis for collecting those 19 attestations. You know, they're -- they're 20 obviously less than I wish they were, but it is what 21 it is. 22 And back during the audit, instead of just 23 dismissing them completely -- and the FTB again 24 could have worked with the taxpayer's rep and said, 25 "Let's go back to these people. Let's see what they 26 know." 27 Mr. Szabo's records, it was clear that 28 during the audit Mr. Szabo was trying to 47 1 substantiate the basis that was claimed and putting 2 together schedules. None of the schedules that he 3 put together ever matched what was claimed on the 4 tax return. 5 So, by that point in time, he clearly 6 didn't know. The people in his office who were 7 originally taking care of the Lowes' account were 8 long gone. 9 So, he was left going back to an incomplete 10 record and trying to put together the pieces. What 11 was there and what wasn't, we don't know. 12 My colleague mentioned that -- the issue 13 over interest. I have no idea whether interest was 14 capitalized as part of this basis or not, but I see 15 absolutely nothing wrong with capitalizing interest, 16 if it was. 17 First of all, construction cost interest, I 18 think, has to be capitalized. The tension in the 19 tax code goes way back. The idea of capitalizing 20 interest is not a new concept. That's been around 21 for a long time. 22 The tension comes from, at least prior to 23 1976, when all interest was deductible, the tension 24 came between what gets deducted and what gets 25 capitalized. 26 So, 266 was there to -- to provide some 27 guidance that indicated that you couldn't get a 28 current deduction for interest if you were 48 1 capitalizing interest. 2 Uniform Capitalization Rule, Section 189, 3 all of those sections were designed to limit the 4 current deductibility of interest that was 5 capitalized. 6 There isn't a single section that is 7 devoted to disallowing the capitalization of 8 interest. 9 So, whether -- whether interest was 10 capitalized or not, I don't know. But I don't see 11 it as particularly problematic. 12 We have talked ad nauseam about the 13 property tax assessment and what happened at the 14 time. 15 The FTB never disagreed during the briefing 16 process when we explained what happened. And the 17 same is true with the house over the garage. 18 I looked and Mr. Williams looked at the 19 plans and at the permits, both of which showed that 20 a house was built over the garage. We thought it 21 was. All of the evidence was there. 22 I think in one of the meetings I had with 23 one of your members suggested, well, if you have 24 plans, you can get an estimate. We did exactly that 25 when we -- when Mr. Williams was doing his report. 26 So, that was an honest mistaken belief that 27 based on the plans and the permits that that was 28 built. 49 1 The master bath, Sheryl, maybe you'd like 2 to address the master bath, if they think -- 3 MS. BERKOFF-LOWE: Of course, there was a 4 master bath. When -- we stated we built a master 5 bath after that. I think that she had mentioned 6 that every master has a bathroom and we had one. 7 What we did is we renovated ours. And we 8 added on to Rob's closet. We added a vanity in mine 9 and redid all the cabinets. It was pretty 10 substantial. And that's what the difference is 11 here. 12 And also, by the way, we did have a guest 13 house. It was the pool house. And then we were 14 going to build a guest apartment for family members, 15 which we just didn't. We didn't do, but we pulled 16 permits for it. 17 So -- but we had an extensive guest house 18 that, you know, when you're building you call it a 19 pool house, but it did have a bedroom, a living 20 room, a kitchen and the bathroom. So, we could have 21 guests stay in it, hence, why we called it the guest 22 house. 23 Anything more? 24 MR. BERNSLEY: So, the FTB conveniently 25 ignores Mr. McAllister -- Mr. McAllister's 26 declaration. 27 He's here and I may call him up ask him to 28 speak a little bit. 50 1 Carl Williams' methodology has been 2 challenged. Carl has been around a long time. Carl 3 is not a professional witness. 4 MS. BERKOFF-LOWE: Also can I say one thing 5 really quick too? 6 When she was calling it a renovation, it 7 just struck a chord with me because it wasn't a 8 renovation. We did build it from scratch. 9 But in order expedite permits, we kept an 10 original foundation and a couple of walls. And a 11 lot of people do that. 12 In the long run it ended up costing us more 13 to do that. So, in hindsight, we should have 14 waited. 15 But I wanted to address that too. 16 MR. BERNSLEY: And it's also my 17 understanding that it's -- it's saved for the 18 permit, but it's then torn down and replaced anyway. 19 And this was a revelation to me, quite 20 honestly, because when -- when the FTB was 21 questioning Mr. Williams and he first said that the 22 framing and the concrete that was initially allowed 23 was then torn down and replaced, I didn't know what 24 to think, 'cause I -- you know, I didn't have a clue 25 about that being done. 26 I had the misconception that the FTB 27 counsel had, that -- that part of that was 28 remaining. 51 1 And when Mr. McAllister did his declaration 2 and essentially did the same thing, including zero 3 foundation and zero framing, as I understood, I 4 asked him about that. 5 And he said we wouldn't leave that up. And 6 it finally dawned on me that there is an incredible 7 difference of perception here between the FTB expert 8 and experts like Mr. Williams and Mr. McAllister, 9 who were dealing with 10, 15, 20, $30 million homes, 10 as opposed to a tract home. 11 If you're dealing -- if you're building a 12 small tract home and you can save some money on the 13 foundation or the framing, you save the foundation 14 and the framing and save some money. 15 But if you're building a $15 million home, 16 you don't want old wood and old foundation there. 17 You rip it out and you replace it. You're not 18 building a gorgeous mansion around leftover pieces 19 from some old construction. 20 That's my interpretation. 21 The Nulty contract was done in a couple of 22 parts. The attestation is confusing. There is part 23 of the Nulty contract that was based on the initial 24 plans. And another part of the Nulty contract was 25 for basically supervising the construction. And he 26 got paid in different ways. 27 MS. BERKOFF-LOWE: And I also want to say 28 that Don Nulty is and was a good friend of mine. 52 1 And he took a pay cut to do this job, knowing it 2 would be a trophy piece and would probably be in 3 multiple publications. 4 And he became extremely busy during the job 5 and asked, you know, because I was a bit controlling 6 on the job and doing sketches myself and saying, 7 "Let's make the hallway like this," and drawing it 8 and Don was just like, "I'm crazy busy, you can 9 micro manage it." 10 So, he did take a pay cut. And it was done 11 in stages, which I worked with him a couple times 12 and that's what -- 13 MR. LOWE: The point being that any 14 contract that says, you know, what Don's fees are 15 going to be are any way representative of anything 16 is just not valid. 17 It's sort of the same thing, if I'm doing a 18 film and they run behind and things -- you know, 19 I'll say, "Yeah, I'll give you those days for free." 20 It's -- it's the same concept with Don. 21 MR. BERNSLEY: Insurance -- I don't -- I 22 don't know the bottom line about insurance, but what 23 we know from this record is that there was a 24 substantial amount of nonrecurring costs that one 25 would not insure. 26 And, as I see it, there was also a certain 27 amount of, in my lay opinion or my lay words, 28 inefficiency by doing a construction project 53 1 piecemeal as opposed to straight all the way 2 through, you add costs. 3 So, when you look at it like that, the 4 potential gap between the insured amount and the 5 actual costs is much, much smaller, and probably 6 within range of how different things get allocated. 7 The FTB seems to rely a lot on Harding and 8 his appraisals. But I'd like to read you a couple 9 of comments from appraisal -- or from John Harding's 10 declarations, particularly as used by -- well, 11 including as used by Mr. Kruckenberg. 12 Mr. Harding says, 13 "I would not expect my estimate of 14 reproduction costs to match or predict what 15 the Lowes actually spent. 16 "Determining actual costs was not 17 the purpose of my appraisal. The cost data 18 estimates from local sources were not 19 obtained specifically for Garden Lane. 20 "My estimates of construction 21 costs cannot be presumed to predict or to 22 have predicted the actual costs for any 23 given project. 24 "Mr. Kruckenberg's use of my 25 appraisal makes invalid assumptions about 26 the meaning of parts of my appraisal and 27 takes portions of my appraisal out of 28 context. 54 1 "I am not an expert in 2 construction costs or the determination of 3 what construction costs for any given 4 project were or would be. 5 "I have never been involved in the 6 construction of a home." 7 MR. LOWE: I have to say, when I -- excuse 8 me. 9 When I read that, I was flabbergasted. 10 This is the witness that the Board is basing much of 11 this on. 12 And, you know, from where I come from as a 13 long time taxpayer, it speaks to a certain mind set 14 that is looking for a preordained outcome, as 15 opposed to what is actually likely, logical and 16 fair. 17 MR. BERNSLEY: And if you look at 18 Mr. Harding's appraisal, his last appraisal was $13 19 million. The house sold about a year later for $25 20 million. So, he was wrong. 21 He also stated that the house was on par 22 with other houses in the community. Yet if you look 23 at -- did I say it was HE 13, it's one of the 24 exhibits there toward the end. 25 No, it's -- 26 MR. LOWE: 17. 27 MR. BERNSLEY: -- it's 17, it's the last 28 exhibit. 55 1 If you go back, you can see the comparable 2 sales -- not comparable, but they're contemporary 3 sales. And the Garden Lane house was head and 4 shoulders above anything else selling in the area. 5 So, you know, this isn't about bashing 6 Mr. Harding, but he had a job to do. He was 7 appraising the property. 8 And when you appraise the property for a 9 bank loan, really the bottom line is does it 10 appraise high enough for the loan to be issued or 11 not. 12 And to suggest that you can determine what 13 the house really costs based on what a real estate 14 appraiser comes up with is pretty far-fetched. 15 Maybe Carl -- 16 MS. RICHMOND: Time has expired. 17 MR. BERNSLEY: What's that? 18 MS. RICHMOND: Your time has expired. 19 MR. BERNSLEY: I think we have about five 20 minutes left from my initial presentation. 21 MR. HORTON: We will allow it. 22 MR. McALLISTER: How you doing? 23 MR. BERNSLEY: Maybe Matt can talk to what 24 this house would cost. 25 MR. HORTON: Pardon me, sir, could you 26 please introduce yourself for the record? 27 MR. McALLISTER: Matt McAllister, I'm a 28 builder in Montecito. 56 1 You know, I built the Lowes' home, their 2 home they live in now. I'm familiar with building. 3 I've lived in Montecito, raised my kids there. I 4 went school there, been there for 30 years. 5 There's no way -- just hearing some of 6 these -- just hearing some of these numbers, like, 7 you know, $119,000 to frame the house. That's 8 just -- that's laughable. I couldn't even frame a 9 four-car garage for that. 10 I mean, the house got -- no doubt was 11 gutted down to -- the studs were all gone. I'm sure 12 they had to redo quite a bit of the foundation in 13 order to just upgrade it to get to the earthquake 14 standards at that time, which -- they get seriously 15 difficult every year. 16 But, you know, I couldn't even -- you know, 17 when Rob said, you know, 10,000 square feet, if you 18 really look at the plans and you look at the out 19 buildings and everything there -- and they don't 20 include the covered porches in their -- in their 21 gross square footage -- the house is really around 22 14,000. 23 This is simple math with a house like this. 24 It's -- you know, even if you conservatively put it 25 at a thousand square foot, and it's 14,000 square 26 feet, you can do the math there. 27 There is obviously a big hole here between, 28 you know, what they're saying. And it's -- it 57 1 doesn't make sense. 2 I couldn't get the house built, finished 3 like this. I mean, there is real plaster moldings 4 around the whole house. There's probably a thousand 5 linear feet of it and it's not foam. You know, 6 that's 80 or $90 a linear foot just to put it up 7 there. A real -- you know, artisans to do all that 8 work. This is not foam. 9 So, you probably got 80,000, 100,000 just 10 in the molds on the house. So, I mean that's just 11 probably one of 500 items. It's just not -- it's 12 not doable. 13 The plaster, the exterior plaster, they 14 don't just put the stucco on, it's -- you know, it's 15 a three-coat process. This would have been done in 16 expanded metal. It wouldn't have been done in 17 chicken wire or -- and it takes a special person to 18 put the type of troweling that would have been done 19 on this house. 20 And then, after you complete all that, 21 you've got, you know, this English manor look 22 that -- you know, with the paint that was -- there 23 was three or four coats in that process right there. 24 It's just -- it's just -- you know, you've 25 have got Vermont slate on the roof. You know that, 26 in itself, weighs a lot. So, they would have had to 27 figure something in the foundation for that. 28 Because it's -- it's like, you know, putting 58 1 boulders on the roof. So, they would have had to 2 reengineer everything down to the foundation. 3 MR. LOWE: And again, I just want to say, 4 I'm just struck with Mr. McAllister's testimony 5 being described by the FTB as "general." It doesn't 6 sound very general to me. 7 MR. McALLISTER: There is nothing -- you 8 know, everything in the house, it's just -- it's 9 just there's no way you can do it for $4 million, 10 not at that time. 11 It's just -- it would have been -- they 12 would have left the project and, you know, they 13 wouldn't have had a house. 14 The other thing is with this is -- you 15 know, the reason they probably went through this 16 process is it's a lot easier to get to -- to get 17 moved in if you don't scrape the house, 'cause you 18 probably won't get back what you had there. 19 The County's going to go, "Well, you can't 20 have this. You can't have that." They're always 21 trying to scale things back. 22 And the architects are always trying to 23 shrink it and say it's less square footage than it 24 is because they're trying to get the owner what he 25 wants for square footage. 26 So, there's always this numbers business 27 that they play down there. And who physically comes 28 out and measures it? You know, nine out of ten 59 1 times nobody measures anything from the County or -- 2 and-or. 3 But it's simple math there. It's -- you 4 know, it's 14,000 square feet of buildings. You 5 know, we've got an 800 square foot pool house, 6 you've got a 500 square foot garage -- 550 garage, 7 you've got a 500 percent guest house. You've got a 8 carport. 9 You've got -- you know, the -- there's also 10 the underground, the infrastructure that called out 11 a 400 amp panel. I know that the 400 amps wouldn't 12 have ran this house. It's not possible. 13 But, I know I'm getting into a lot of 14 minutia. And really the minutia just boils down to 15 the big picture of what's doable here. 16 And it's -- quite frankly, it's -- I 17 couldn't build it for four and a half million and I 18 just done with a house that is very similar square 19 footage, so, I won't go into finances of that. 20 But even if you -- you know, say it was 14 21 today and you dropped 30 percent off that, you're 22 probably down at nine or ten. And then you throw 23 back in all the softs costs, you know, architectural 24 fees, designer fees -- you're right back up there. 25 It's -- I just want to keep it short and as 26 for, you know, my budget, I mean -- 27 MR. BERNSLEY: If I may, I'd like to 28 briefly address Mr. Kruckenberg and his expert 60 1 report. 2 I have addressed part of this on brief, but 3 briefly, he didn't use a recognized methodology 4 consistent even with his own statements of how 5 contractors would estimate the cost of a home. 6 He said time and materials and 7 subcontractor bids. He didn't use any of those. 8 He relied on his -- for his starting point 9 on numbers from Mr. Harding's appraisal. And, as I 10 explained, Mr. Harding himself said you can't do 11 that, my -- I don't know -- I don't really know much 12 about costs. I get them from somewhere else. Alone 13 that should be enough to ignore Mr. Kruckenberg. 14 His process was then to make adjustments to 15 Mr. Harding's number, using Mr. Williams' numbers, 16 which were the very numbers he was trying to 17 discredit. That makes absolutely no sense. 18 And as distasteful as it is to challenge 19 somebody on this basis, it is my duty to my client 20 to point out that Mr. Kruckenberg was telling the 21 California State License Board that he had no 22 employees and, therefore, needed no workers' 23 compensation insurance at the same time that he was 24 suffering tax liens from employment taxes. 25 So, clearly he had employees. And he was 26 clearly willing to lie for whatever was expedient at 27 the time. 28 And it's my duty to point that out, 61 1 distasteful as it is. 2 So, again I think Rob's point is well taken 3 that the focus of the FTB has been to support their 4 bottom line number, the number that they have had 5 since the beginning. 6 And, as I said, it really doesn't make a 7 lot of sense here. It doesn't fit into a viable 8 statement of fact. 9 And what we have supporting the taxpayers' 10 position, supporting their basis, is Garden Lane 11 itself and the majestic property that it was. 12 Some limited financial information, but 13 clearly inadequate proof that that financial 14 information was incomplete: 15 Early reliable computations by 16 professionals with no reason to fabricate 17 and every reason to get it right and no 18 concerns over accuracy; 19 Returns signed under penalty of 20 perjury and certified by the CPA; 21 Two expert opinions that support the 22 validity of the return; 23 Property tax assessments post sale 24 that can be discounted back, and they 25 support the numbers on the return; 26 IRS records and statistics showing 27 that they support the basis on the 28 return; 62 1 Opinions of the tax assessor employee, 2 who had no ties to this case -- and it was 3 really sort of serendipitous that I even 4 found him and he was willing to provide a 5 letter -- and he supports the idea that 6 the actual cost of this property had 7 to be consistent with what the Lowes put on 8 their return; 9 And multiple listing service data 10 showing that this house really did stand 11 out from the others on the market. 12 So, there's really a plethora of 13 information that in totality shows that this -- this 14 was unique. 15 And, unfortunately, we don't have the 16 records that prove that beyond a reasonable doubt. 17 But the standard here isn't a reasonable doubt, it's 18 more likely than not. And I think we've shown that. 19 MR. McALLISTER: One last thing I just 20 wanted to mention, which -- Sheryl and Rob, they 21 always -- they paid their bills. You know, there 22 was never any problems on the site. And, you know, 23 Sheryl directed everything and Rob wrote the checks. 24 So, usually when people are paying their 25 bills, they pay their bills, I mean, especially on a 26 scale of that. 27 Why would you not pay your bills somewhere 28 else? I don't -- I just wanted to mention that. 63 1 MR. LOWE: Thanks. 2 MR. HORTON: Okay. Thank you. 3 MR. LOWE: The lesson today is pay your 4 bills. 5 MR. HORTON: All right. 6 Members, there's an issue for clarification 7 on this non capitalized interest. I am going to go 8 to the Appeals just to clarify the legality of that. 9 I believe that -- at least to me, that is 10 somewhat new. 11 Appeals. 12 MR. AMBROSE: Yes, Mr. Chair. 13 Under IRC Section 266, a taxpayer may elect 14 to capitalize rather than deduct otherwise 15 deductible interest and taxes on property. 16 Under 163, debt incurred by taxpayer to 17 acquire property is -- can be expensed. However, 18 there is limitation of $1 million for qualified 19 residence interest. 20 So, in other words, you can expense 21 acquisition indebtedness to a million dollars, 22 therefore, that's going to be deductible and that -- 23 they can elect to capitalize that. 24 Anything over that would be considered not 25 deductible, therefore, not able to be capitalized 26 and added to basis. 27 MR. HORTON: Okay. 28 MR. BERNSLEY: Can I respond to that? 64 1 MR. HORTON: To the -- yes, then we'll -- 2 MR. BERNSLEY: Mr. Ambrose is correct with 3 respect to what 266 says in terms of capitalizing 4 otherwise deductible interest. 5 However, that is not the exclusive way to 6 capitalize interest. Not everything that gets 7 capitalized has to go through 266. 8 266 by itself just talks about carrying 9 charges, doesn't even specifically mention in the 10 statute interest, although it's understood that it 11 applies to interest. 12 But -- particularly as an example, 13 construction period interest is -- actually, it 14 was -- it was precluded from deduction under 15 Section 189, however -- no, it was required to be 16 capitalized under 189, you couldn't get the 17 deduction. 18 But construction period interest has always 19 been capitalizable and is capitalized regardless, 20 even -- even though it is not currently deductible 21 because, for example, the Lowes didn't live in 22 Garden Lane when it was being constructed. 23 So, the interest had to be capitalized. It 24 couldn't be deducted during that period because it 25 wouldn't qualify as residence interest 'cause it 26 wasn't their residence yet. 27 So, interest can be capitalized apart from 28 Section 266. 65 1 MR. HORTON: Department? 2 MS. WOODRUFF: Well, I dis- -- I agree that 3 mortgage -- mortgage interest certainly cannot be 4 capitalized over one million dollars, as Mr. Ambrose 5 stated. 6 There's also a couple of Tax Court opinions 7 on the matter. There are a few citations here, 21 8 Tax Court 197, in Isaiah Megibow, the taxpayer 9 attempted to capitalize mortgage interest and 10 property taxes to increase his basis. And the court 11 rejected this argument because those expenses are 12 not carrying charges. And sound accounting 13 principles do not permit the capitalizing of such 14 expenses. 15 So, it's possible that some amount of 16 carrying charges, as Mr. Bernsley point out -- 17 pointed out, might be deductible, but certainly not 18 up to $2 million, which is what they attempted to 19 capitalize at protest. 20 MR. HORTON: All right. Thank you very 21 much. 22 Lawyers can disagree. 23 MS. HARKEY: Good for them. 24 MR. RUNNER: Yes, they can. 25 MR. HORTON: Discussion, Members? 26 Member -- 27 MS. HARKEY: I'll go first. 28 MR. HORTON: -- Harkey. 66 1 MS. HARKEY: I am -- I'm stepping up 2 because nobody else is, but I reserve the right to 3 come back when I have my -- 4 MR. HORTON: Always, always. 5 MS. HARKEY: -- just like you guys. 6 I have reviewed Kruckenberg's analysis and 7 it, in my mind, is not credible. 8 And I base this on my past experience, what 9 I would have looked to. I did some background 10 research just to see what he'd worked on. And 11 basically it was pretty much homes around half a 12 million dollars, nice -- some of them are nice and 13 whatnot, but they're not -- they're not customs. So, 14 I had a real problem really relying on that. 15 We heard the difference between the guest 16 house versus the pool house, I believe that was even 17 discussed previously, and the master bath. 18 One of the areas, I think, where I believe 19 there's a big discrepancy is I believe -- and you 20 can correct me if I'm wrong, FTB -- but that you're 21 saying that most everything was done by 1999? 22 MS. WOODRUFF: That's right. 23 MS. HARKEY: Okay. And I believe that the 24 Lowes are saying no, that's not true. 25 I think -- was 1999 when you had the 26 construction loan? Was that -- were those the 27 documents you were looking at? 28 MS. WOODRUFF: No. As of 1999 is when we 67 1 have the final sign off of the building permit, 2 completion of the main house. 3 I'm really talking about the completion of 4 the main house in 1999. Work -- they did continue 5 to do some work after -- after 1999 and all the way 6 until they sold the house. However, the substantial 7 amount of work was really completed as of 1999. 8 So -- and you see that when you look at 9 Mr. Harding's -- some of the narrative descriptions 10 in his appraisals. He talks about the house being 11 complete as of 1999 and occupied and only the pool 12 house finishing remains to be done. The actual 13 construction pool house was done, it was just the 14 interior needed to be finished. 15 And also a couple of other items, such as 16 -- mostly outdoor items, the landscaping, addition 17 of decks and that sort of thing. 18 MS. HARKEY: Right. We have a 19 documentation on the extensive amount of 20 landscaping. And if I -- I believe that was the big 21 -- that was a huge, huge expense, also some of the 22 further improvements. 23 So, what you're saying is that the main 24 house was substantially complete, but the 25 landscaping may not have been. The pool house 26 wasn't done. A variety of other things -- and they 27 could conceivably renovated, as they said, redone 28 their master bathroom. 68 1 MS. WOODRUFF: Right. 2 MS. HARKEY: And added a few extras in the 3 main house after 1999. 4 And which I believe they are saying they 5 did do. 6 So, you don't -- 7 MS. BERKOFF-LOWE: I could name those if 8 you need me to. 9 MS. HARKEY: I'll be with you. 10 I'll be with you. 11 Okay. So, I think that's one of the main 12 fault lines here is the 1999 versus when the house 13 was actually completed. 14 The concrete estimate, now I happen to 15 know -- I spent 30 years in banking and corporate 16 finance and the majority of my time was done in, you 17 know, helping contractors build homes, in essence. 18 I mean, you know, I did from large builders to small 19 guys, depending on what level of my banking career. 20 And it's much easier when you're doing an 21 existing property, much easier to get -- pull 22 permits if you claimed that you are doing a remodel. 23 And the only thing that needs to be up for remodel 24 is maybe a piece of a frame and maybe some of the -- 25 some of the concrete. 26 But, generally speaking, that's the only 27 reason you do that. You go for new construction, 28 you have to -- I mean, it's a whole process, it's 69 1 years long. 2 It's all the neighbors deciding what you 3 can build again. It's, you know, changing the 4 footprint. It's everything. 5 Even if -- even if you had a house that was 6 on a footprint, if you have a lot of protests or 7 complaints, then you may have to decrease that. 8 So, you don't really -- you try to keep 9 with what you've got just for the permitting 10 process. 11 Now on a house like this, even though you 12 may have left up a little wall, you probably would 13 end up having to redo all of the -- all of the 14 foundation if only because of the current building 15 codes. 16 So, I think the foundation expense for 17 something like this that also had the slate roof, 18 they make a lot of sense. It really probably had to 19 be totally redone. 20 So, I think concrete estimates may be off 21 or maybe just you're only getting a piece of 22 information from that. 23 We heard about the Nulty renovation -- at 24 least the explanation about Nulty. 25 Okay. Again when you -- when the FTB 26 mentions the Szabo report to the assessor, that was 27 1998. So, that was his estimate at that point. 28 The insurance seemed to be a big point of 70 1 contention. What is your understanding about 2 insurance coverage? 3 MS. WOODRUFF: My understanding -- and this 4 is just, you know, it's from speaking to people 5 knowledgeable about insurance, is that you need to 6 insure the property to the full replacement cost in 7 order for your homeowner's insurance to accept or 8 for the bank to accept your homeowner's insurance. 9 MR. HOFSDAL: And we reviewed the policy as 10 well -- 11 MS. WOODRUFF: Right. 12 MR. HOFSDAL: -- in this case and this 13 policy called specifically for that. 14 MS. HARKEY: Okay. 15 Ms. Lowe. 16 MS. BERKOFF-LOWE: Hi. 17 MS. HARKEY: How are you? 18 MS. BERKOFF-LOWE: Doing well. 19 MS. HARKEY: Explain your insurance. 20 MS. BERKOFF-LOWE: I pay car insurance. I 21 don't know, explain my insurance? 22 MS. HARKEY: The insurance pertinent to 23 this house. 24 MS. BERKOFF-LOWE: I mean, you know, I -- I 25 would defer to Mark on that because my expertise is 26 design and overspending. 27 So, I -- you know, if anything, I mean, I 28 would imagine that what we did was insure partially. 71 1 I mean, that's what makes sense. I mean, I 2 could tell you that it wasn't based on the value of 3 our property. 4 MS. HARKEY: Right. I -- 5 MS. BERKOFF-LOWE: You know, we -- that's 6 clear to everybody, not to sound condescending, but, 7 you know, we made a decision, probably based on our 8 finances at the time, which we tend to do. 9 MS. HARKEY: That's understandable. 10 And as long as it was insured for the value 11 of the mortgage -- 12 MS. BERKOFF-LOWE: Exactly. 13 MS. HARKEY: -- you wouldn't -- 14 MS. BERKOFF-LOWE: Which is probably what 15 we based it on. 16 MS. HARKEY: -- wouldn't have any problem. 17 I don't think my house is insured for the 18 total value of the house right now. 19 MS. BERKOFF-LOWE: I mean, you know -- 20 MS. HARKEY: But that's -- 21 MS. BERKOFF-LOWE: You could over -- I 22 mean, the insurance conversation is weekly in the 23 Lowe household, so, I mean -- 24 MS. HARKEY: Okay, thank you. 25 I won't ask this question because FTB has 26 removed the failure to file penalty. 27 When -- when did you -- what happened in 28 1999 -- between 1999 and when you say that you were 72 1 complete with construction? 2 Yes, you're still on, I'm sorry. 3 MS. BERKOFF-LOWE: That's okay. 4 So, the question to me is what -- what went 5 on in the -- 6 MS. HARKEY: Right. 7 MS. BERKOFF-LOWE: -- interior of the main 8 house after we got our occupancy? 9 MS. HARKEY: Yeah, because the schism here 10 seems to be that the FTB seems to think you were 11 through in 1999 and you don't. 12 MS. BERKOFF-LOWE: Now we're in my area. 13 Well, to begin with, we -- when we moved 14 in, we didn't have the money to complete. 15 So, we left the guest house -- pool house 16 by the pool -- as a shell, literally studs and 17 plaster on the outside. So, we did that. 18 We replaced -- we redid all stone around 19 the pool. It was grass growing up to the coping. 20 We did all antique French pavers. 21 We did -- what almost made Rob very mad at 22 me many times -- is the conservatory, flown in from 23 England, the Amdega, that was built. 24 We did -- the blinds in there came through 25 Amdega. We did the sink in there, the floor. I 26 mean, I wanted it like a room that you could sort of 27 eat breakfast in and hang out, not just do potting 28 of plants. 73 1 We built an outdoor kitchen, next to it. 2 Like, you know, one thing led into another with 3 that. And we put in custom French doors from the 4 kitchen to the family room, which were ginormous. 5 We redid the master, added my vanity. We 6 redid Rob's closet completely. We actually redid my 7 closet as well in that mix. 8 We added built-ins in the boys' rooms. 9 We -- it goes on and on and on, we re -- we added 10 and renovated in the screening room, modified it for 11 new projection systems, compared to when we first 12 moved in. 13 We -- oh, that's right, we did -- the in 14 basement we were having severe problems with leak 15 and we started to get like early stage mold, so, we 16 added a new state of the art system at the time 17 called ATMOX. They put fans in all of the ducts and 18 I mean was really like state of the art back then. 19 And that was a substantial amount of money. 20 But that was -- I have son with asthma. 21 So, a lot of the stuff that we did -- hepa filters, 22 organic paints, like I was saying, that adds 10 23 percent to your cost when you take in mind that, you 24 know, the paint was flown from here and there. And 25 we didn't use glue in our wood floors. It was all 26 nails and a special kind of wood, pesticide free. 27 And I'll look through my notes. But I mean 28 that's just right there -- that's some of it. 74 1 We redid the gym. That's right, we put 2 mirrors up on the wall in the gym. 3 Should I go on more and more about all this 4 decadence? I am starting to get embarrassed. 5 MR. LOWE: The tree house. 6 MS. BERKOFF-LOWE: Oh, the tree house -- 7 well, Rob's brother was originally going build that 8 and he started. 9 And it compromised the tree. So, we had an 10 actual professional framer come in and do it, 11 which -- so, it started off to be a labor of love 12 and turned into, you know, like a house the boys 13 could have moved into -- 14 MS. HARKEY: A residence. 15 MS. BERKOFF-LOWE: -- a real nightmare. 16 MS. HARKEY: Okay, thank you. 17 One last question before I cede my time. 18 FTB, have you looked at this book? Have 19 you noticed the finishes? Have you looked at the 20 improvements? 21 MS. WOODRUFF: I have. 22 MS. HARKEY: Okay. There is no way this is 23 $4 million. It just doesn't compute. So, it's 24 something other than that. 25 I had sincerely hoped you would settle this 26 out and not bring it back, but since you didn't, 27 we're probably going to have to make a decision. 28 There is no way this is $4 million. 75 1 So, with that -- oh, we also received an 2 appraisal, a letter from the appraiser, which maybe 3 Ms. Ma can go over since it was addressed to her. 4 So, with that I'll -- 5 MR. HORTON: Member Ma. 6 MS. MA: Thank you. 7 So, Ms. Harkey, I was going to address that 8 letter later, but I might as well do it now. 9 Joe Holland is the assessor in Santa 10 Barbara. He has been working -- started working 11 back -- back in -- started working in the Assessor's 12 Office starting in 1984, in the Real Property 13 Appraisers Section. And he got elected Assessor in 14 2002. So, he's been an appraiser and assessor for 15 31 years. So, I do value his opinion. 16 I called him to verify the letter by Kasey 17 Kump one more time because the letter had a very big 18 range from $800 to $1500 for costs in the Montecito 19 area. So, I wanted him to review his appraiser's 20 letter one more time and give me whatever last 21 minute opinion that he had. 22 And yesterday he sent over the letter 23 showing the roll during the sale in 1995, which 24 showed that they allocated the $25 million sale 25 price, $12 million to the land and $12 million -- 26 12,984,684 to the improvements for the sale of the 27 land. So, that's about $13 million. 28 And based on Zillow -- we looked up Zillow, 76 1 as well as Trulia, I think, is the -- is the two 2 companies out there. And they showed that this 3 Garden Lane property had 11,000 square foot. 4 So, I started doing the calculation. And 5 based on the assessor's allocation, at 11,000 square 6 foot it came out about $1100 per square foot in 7 terms of the construction costs for the home. 8 And that verified Mr. Kasey Kump's letter 9 that said that homes -- comparable homes in the area 10 constructed between 1997 and 2003 would go anywhere 11 between 800 and $1500 or more per square foot. And 12 given that this was an estate of the highest 13 quality, it was his opinion that comparable 14 construction costs would be at the upper range of 15 that amount, which is the $1500 range. 16 So, that's why I had reached out to the 17 assessor just to get his second opinion on his -- 18 his real property appraiser just to make sure that, 19 you know, the numbers are in the range that the 20 Lowes reported. 21 But before I kind of make my statements, I 22 actually would like hear from Mr. Williams. 23 MR. WILLIAMS: Yes. 24 MS. MA: I saw your report. It is very 25 extensive. 26 And I'd just like to know a little bit more 27 about your background, and, you know, how long 28 you've been doing this and how you came to the 77 1 numbers that you came to. 2 MR. WILLIAMS: Well, first of all, I'm 73 3 years old, okay. And I was born 1942. And in 1978 4 I moved to Santa Barbara from Kansas City, Missouri. 5 And I've been working with banks, lenders, 6 savings and loans as a senior vice president and 7 manager of construction loans. 8 I have extensive knowledge as far as costs 9 to complete a property, simply because I've ran or 10 controlled a fund control within the banks. We 11 disburse funds on the line item basis throughout the 12 construction process, from grading through 13 landscaping. 14 We also did the cost analysis prior to 15 recordation of a first trust deed as far as 16 construction is concerned. And I did that for 11 17 years. 18 Opened my business in 1990, and never 19 looked back, and started my own company in the fund 20 control and cost analysis and cost estimating for 21 any type of projects -- all types of projects with 22 industrial, hotels, recreation, education, 23 educational projects, and also single families. 24 My staff pride themselves in the local 25 market, which include the whole branch, which is a 26 high end community and Montecito. 27 Some of the banks I've worked for is First 28 Republic Bank, who is an extensive lender in that 78 1 particular areas -- in those particular areas, and 2 also five or six other banks who pride themselves in 3 lending out in the high end market. 4 Okay, that ranges -- I say high end market, 5 anything over and above $4 million, $5 million, they 6 would make the construction loan. 7 And prior to recordation of the 8 construction loan, they would submit all of the 9 pertinent documentation to me to make sure that we 10 have adequate funds to complete the project on a 11 turnkey basis. 12 We also do the final audit, okay, at the 13 end of the project to determine the final funds -- 14 if it goes to the general contractor or the owners. 15 And then a permanent loan is then invoked 16 as far as the owners are concerned, they pay 17 interest only during the construction loan. 18 I found out during my experience that the 19 cost to complete when a loan is funded, monies are 20 paid out-of-pocket by the owners. And we don't have 21 an accounting of that. 22 Then also during the construction if there 23 is a change order, the owners would pay out of 24 pocket over and above the loan amount. 25 So, it was impossible to track exact costs 26 of any construction project, especially in the high 27 end market because the owners come in and say, 28 "We want this wall changed. We want 79 1 additional cabinets. We want additional 2 built-ins and the whole bit, okay. 3 "We want additional landscaping. We 4 want a rock that come from China or France 5 or whatever." 6 Okay. And, so, those costs are not 7 filtered through the construction loan. 8 And when -- when the Franchise Tax Board 9 indicated that this property could be built for 10 $4 million is impossible, okay, especially in this 11 particular market. 12 In the Montecito area the owners require 13 high end expertise for installation of materials. 14 Okay, they pay a ton of money for the materials and 15 they -- you shouldn't waste just any small iota of 16 those materials -- of those materials. 17 Therefore -- therefore, you need someone on 18 the job that knows exactly what they're doing as far 19 as installation is concerned, especially after 20 drywall and nail and tape. 21 You are talking about crown molding. You 22 are talking about door trim, window trim, floor 23 tile, wall tile, and this type of thing -- all 24 require expertise as far as workmanship and as far 25 as your subcontractors are concerned. 26 Okay. What I did on this particular 27 project, I went to the archives of Santa Barbara 28 County and -- and obtained the plans, okay. That 80 1 was my first start. 2 Secondly, I went to the Building Department 3 and obtained all of the appropriate building 4 permits, okay. And that included the main house, 5 the guest house, and everything that the Lowes had 6 applied for as far as construction was concerned. 7 Then I went to my database, okay, and I 8 used my database only as far as references, as far 9 as location is concerned, okay. 10 I did not use the line items on the cost, 11 okay, for my determination. My determination was 12 based on my expertise, okay, of similar homes that 13 were built in Montecito and in the whole branch 14 areas, okay. 15 I've been doing this for 32 years, okay. 16 And the banks rely on me to look at a project prior 17 to recordation of the first trust deed, as I said 18 before, to assure them that there are adequate funds 19 to complete the project. 20 I put together a cost that would be 21 relevant to the planned specifications and my 22 interviews with appraisers and the contractors in 23 the area that built that home in Montecito, okay. 24 The problem with the -- the appraiser's 25 assessment is that they -- they have a disclaimer 26 within their report that indicate they know nothing 27 about construction costs, okay. 28 And that was clear in the appraisals that 81 1 were done on this -- completed on this project, 2 okay. 3 That's why we have experts on cost to 4 complete, okay. 5 I have appraisers calling me every week, 6 okay, and -- to have conversations with me based on 7 projects that we have in our portfolio, okay. 8 And as far as costs to complete, they use a 9 manual called Marshall & Swift, okay, and they have 10 adaptors and adjustments that they use for certain 11 areas, okay. 12 And, so, this -- this shows clearly that 13 the appraisal is invalid as far as cost to complete 14 is concerned. 15 You can rely on market approach, okay. And 16 that is something that you -- an appraiser is good 17 at. 18 As far as cost to complete, they're not 19 good at it, and I -- I have personal friends who are 20 appraisers, okay. And they do not rely on cost to 21 complete. They don't have the expertise or 22 knowledge. They use the Marshall & Swift manual, 23 okay. 24 The $4.2 million that was original, the 25 loan funds for the Lowes, we don't know exactly how 26 much money was spent. 27 My report clearly indicates that is the 28 lowest amount of money that would be required to 82 1 build that type of a property. Okay, and that's 2 exactly what I did. 3 MS. MA: So, were you the -- like trustee 4 for this loan? 5 'Cause we have a document showing the 6 project cost analysis and the principal disbursed 7 for the loan is 4.75. 8 MR. WILLIAMS: Yes. 9 MS. MA: So, were you the one that kind of 10 helped track -- 11 MR. WILLIAMS: Yes, yes, absolutely. 12 MS. MA: -- the costs? 13 Okay. So, you know, I think the minimum 14 was 4.75, right? 15 MR. WILLIAMS: Right. 16 MS. MA: They got a loan for? 17 MR. WILLIAMS: That's the minimum. 18 MS. MA: Which is higher than the Franchise 19 Tax Board's 4. -- 4.2? 20 MR. WILLIAMS: Right. 21 MS. MA: So, when you start with this bank 22 disbursement form -- 23 MR. WILLIAMS: That was my basis. 24 MS. MA: Right, that's your basis and it 25 doesn't include things for the conservatory, the 26 landscape, the pool house, architectural engineers, 27 interior design, obviously, contingency costs, 28 closing costs and miscellaneous costs, so -- 83 1 MR. WILLIAMS: And that's why I build it in 2 my report. 3 MS. MA: Right, right. 4 MR. WILLIAMS: Okay. 5 MS. MA: We start with 4.75. 6 MR. WILLIAMS: Okay. 7 MS. MA: And then, based on your report, 8 your expert report, I know you concluded that your 9 opinion that the minimum cost to construct the 10 subject property was what the Lowes reported, the 11 9.783? 12 MR. WILLIAMS: I'm not aware of what they 13 reported. 14 MS. MA: Right, but that's -- 15 MR. WILLIAMS: What did they report? I 16 don't know. 17 MS. MA: That's what they reported on their 18 tax return. 19 MR. WILLIAMS: Okay, all right. I mean -- 20 I mean, I'm not -- I wasn't trying to meet their 21 request. 22 MS. MA: Oh, no, I understand, I 23 understand. 24 MR. WILLIAMS: It's what my report is based 25 on. 26 MS. MA: But in your expert opinion -- 27 MR. WILLIAMS: Okay. 28 MS. MA: -- is it reasonable that the cost 84 1 build this house, right, a unique property from 2 ground up, was 9.783 -- so, $9.7 million dollars 3 divided by, I'm using 11,000 square feet, which is 4 $889 per square foot to build this house. 5 Is that, in your expert opinion, high, low? 6 MR. WILLIAMS: That's a minimum amount. 7 MS. MA: Right. 8 MR. WILLIAMS: The minimum amount to build 9 this property, okay. 10 And I calculated the entity -- the 11 supervision, the profit and overhead and a few other 12 items within the project, within my budget, okay. 13 And what I -- what I did was spend a lot of 14 time to give an accurate report, okay, to my best 15 knowledge and expertise on building a home -- 16 monitoring homes within the whole branch in the 17 Montecito areas. 18 MS. MA: Thank you, Mr. Williams. 19 MR. HOFSDAL: Just to clarify, the amount 20 that was reported on the return was about 10.5, 21 which is a little bit higher. 22 MS. MA: Okay. 23 MR. HOFSDAL: So, he's testified that it 24 was in the range. 25 MS. MA: Right, okay. 26 So, you do the same math. 27 ---oOo--- 28 85 1 ---oOo--- 2 MS. MA: Right. Okay. So I mean, you do 3 the same math, I mean 10.5 divided by 11,000, you 4 know, is still on the low end of -- 5 MR. BERNSLEY: I just wanted to be -- I 6 just wanted to be clear on the record. 7 MS. MA: -- of the assessor's value. 8 MR. HORTON: Mr. Runner. 9 MR. RUNNER: Yeah. Just a couple of 10 follow-up. I think, you know, I'm interested in 11 terms of the conversations and the questions that 12 have gone on before. But let me just -- just see if 13 I can clarify. 14 In regards to FTB's estimates and the -- 15 after the -- after the construction, from FTB's 16 perspective, was completed, which was the 1999 year, 17 did you add any additional money to basis after 18 that? 19 MS. WOODRUFF: Yes. So -- 20 MR. RUNNER: And what -- how much was that? 21 MS. WOODRUFF: So, about 3.3 million was 22 the amount as of 1999. So the additional amount, 23 you know, almost a million dollars, accounts for 24 that work post 1999. 25 And just quickly, if I might add -- 26 MR. RUNNER: Well, let me -- okay, go 27 ahead. 28 MS. WOODRUFF: Just very quickly. As to 86 1 the $4.75 million figure for the loan amount, a 2 large -- significant amount of that loan went to the 3 refinancing of the original existing loan. So only 4 about $2 million of that loan -- total loan amount 5 went to construction costs. The rest of it went to 6 refinancing the existing loan that was on the -- the 7 purchase of the property. 8 MR. RUNNER: Let me just, in terms of the, 9 um, the comments, um, that were included in the, 10 um -- the appraisal. 11 MS. WOODRUFF: Right. 12 MR. RUNNER: In regards to expertise, in 13 regards to appraisal. 14 MS. WOODRUFF: Sure. 15 MR. RUNNER: Um, did -- how did -- I guess 16 I'm questioning as to how it is that your contractor 17 reflected those adjustments in their -- in 18 their esti- -- in their estimates? 19 MR. RUNNER: That would be fine. 20 MR. KRUCKENBERG: I'm not completely clear 21 on the question. 22 MR. RUNNER: The question is that -- that 23 my understanding is that you used a lot of the -- 24 the basis for your numbers on the Harding 25 appraisals. 26 MR. KRUCKENBERG: Yes. 27 MR. RUNNER: And within the Harding 28 appraisals he comments in regards to his inability 87 1 to, um -- to accurately create value for some of the 2 finishes and the -- and the construction of the 3 home. 4 So my question is, how did you then adjust 5 when -- that, based upon what the appraiser said he 6 was inadequate to be able to do? 7 MR. KRUCKENBERG: What I relied on from 8 that report was more so square footages, scope of 9 works, the finishes that he mentioned, things like 10 that. I didn't necessarily rely on numbers that he 11 had come up with. I relied on what he -- 12 MR. RUNNER: But he said he wasn't capable 13 of doing the finishes. 14 MR. KRUCKENBERG: Well, he was capable of 15 explaining what they were. 16 At the time we were doing our bids, we had 17 very few pictures. And I was basing my numbers off 18 of the plan set. The plan set shows a remodel of an 19 existing -- existing structure. 20 MR. RUNNER: You never went into the 21 property? 22 MR. KRUCKENBERG: No, I've never seen the 23 property. 24 MR. BERNSLEY: Nobody -- none of the 25 experts did. 26 MR. RUNNER: Okay, okay. I was just 27 checking. 28 MR. KRUCKENBERG: So I based everything off 88 1 the plans. What I used Mr. Harding's report for was 2 descriptions of rooms, descriptions of finishes, 3 things like that. 4 MR. RUNNER: I guess I'm confused because 5 in his -- in his report he said he wasn't capable of 6 commenting value on some of the finishes. 7 MR. KRUCKENBERG: Again, I'm not saying 8 I -- I relied on him for values. I relied on him 9 for description of finishes, because I hadn't seen 10 the home. 11 So my question is, did you do any 12 adjustment to yours based upon the fact that he said 13 his -- he was not capable of creating -- 14 MR. KRUCKENBERG: I did all -- I did all of 15 my own numbers based on his descriptions of certain 16 things in the home. I didn't use anything that he 17 put a value to. I put my value to his descriptions. 18 Basically looking at the plans -- 19 MR. RUNNER: Mm-hmm. 20 MR. KRUCKENBERG: -- which, again, are 21 called out as a remodel and a less than 10 percent 22 addition to an existing structure. The permits 23 validate that as well. 24 MR. RUNNER: Mm-hmm. 25 MR. KRUCKENBERG: His report basically 26 described things for me, things that I didn't see 27 because I was unable to see the house. So that's 28 the -- that's what I used his report for. 89 1 MR. RUNNER: Okay. Let me ask, in regards 2 to the -- to Mr. McAllister, FTB has kind of, I 3 guess, generally referred to the home as -- I forgot 4 the phrase, but basically it was -- I don't -- I 5 don't mean this demeaning, but in terms of an 6 ordinary up-scale construction in the Montecito 7 area. Is that close? I can't remember exactly your 8 words. 9 MS. WOODRUFF: Yeah, I mean I think what 10 I'm try -- what I was trying to convey is that it 11 was on par with the other estate-quality homes in 12 Montecito. 13 MR. RUNNER: Let me just ask, you're a 14 contractor, have built apparently many homes in that 15 area. Where was this home in terms of its 16 uniqueness? 17 MR. McALLISTER: It was on a different 18 level, for sure. 19 MR. RUNNER: Can you speak up to the mic 20 there? 21 MR. McALLISTER: It's on a different level. 22 It's -- everything about the home. There's -- you 23 know, plans are 70 percent complete when you get 24 'em. And there's another 30 percent that go into 25 that house that's not even on the plans. And if you 26 build those homes, you're already going to know when 27 you bid it. 28 Like, for instance, the floors, they don't 90 1 want to hear anything in the house, so everything's 2 cast iron. The water, you don't want to -- the 3 floors are inch-and-a-half concrete upstairs 4 everywhere. Then there's probably two or three 5 layers of cork. Then in between the floors, you 6 might have raw wool insulation because they don't 7 want -- and then there might be quiet rock 8 underneath at $50 a sheet. 9 So there's a lot of things that you see a 10 set of plans and there's just -- 11 MR. RUNNER: Even -- I guess in reference 12 to this particular home, though -- 13 MR. McALLISTER: Yes. 14 MR. RUNNER: -- this would not be what you 15 would think of -- again, there's a whole lot of 16 high-end construction in Montecito obviously. 17 MR. McALLISTER: Yes. This would be on the 18 other end. 19 MR. RUNNER: This would be on the high high 20 end -- 21 MR. McALLISTER: Yes. 22 MR. RUNNER: -- of the upper end. 23 MR. McALLISTER: Absolutely. I mean, the 24 picture says a thousand words. You can tell just by 25 looking at the detail on it that it doesn't look 26 like a McMansion. You can see, you could come down 27 to -- 28 MR. RUNNER: A McMansion. I got that. 91 1 MR. RUNNER: Uh-huh. 2 MR. McALLISTER: -- you know, just looking 3 at this home, just in that picture which says a 4 thousand words right there, but that's a stunning 5 home. 6 MR. RUNNER: Okay. 7 MR. McALLISTER: It's -- it's beautiful. 8 MR. RUNNER: So let me go back to 9 Mr. Kruckenberg then in regards to that. 10 Given the basis of that description in 11 regards to the -- to the difference between that 12 home and what we would think of as the -- the 13 ordinary extravagant homes that we would find there, 14 how did you value that? 15 MR. KRUCKENBERG: I actually see the house 16 as what I would call museum quality. 17 MR. RUNNER: Mm-hmm. 18 MR. KRUCKENBERG: And I have built these 19 homes. Unfortunately, I don't know where you didn't 20 find those. 21 I've built homes up to -- 22 MR. RUNNER: Go ahead. Keep talking to 23 me. 24 MR. KRUCKENBERG: -- 21,000 square feet. 25 I've built homes up to 21,000 square feet in Rancho 26 Santa Fe, Napa Valley, Santa Rosa, currently 27 building in Pacific Palisades. 28 MR. RUNNER: Mm-hmm. 92 1 MR. KRUCKENBERG: I'm in plan check 2 actually in Montecito on a house. 3 MR. RUNNER: As a contractor, you believe 4 you could have built that home on that museum 5 quality for the 400-and-some-odd-dollars a square 6 foot? 7 MR. KRUCKENBERG: No. One thing that I 8 want to make clear -- 9 MR. RUNNER: Well, hold on. Let me ask 10 you, that's what my question is. 11 There's a different standard when you're 12 doing remodel construction as opposed to new 13 construction. 14 MR. RUNNER: Right. 15 MR. KRUCKENBERG: And to put a square-foot 16 value on a remodel construction is hard to do 17 because there's certain components, i.e. foundations 18 and lower level framing, that are not part of that 19 plan. 20 MR. RUNNER: Right. 21 MR. KRUCKENBERG: And on the plans that I 22 was looking at when I was putting my costs together, 23 the foundation system says "existing." 24 MR. RUNNER: Yeah. Right. 25 MR. KRUCKENBERG: The lower level exterior 26 walls say "existing." 27 MR. RUNNER: Right. 28 MR. KRUCKENBERG: So there'a a room 93 1 addition section in the middle, on the second floor. 2 There's a 300 square foot popout to one side. 3 MR. RUNNER: Right. 4 MR. KRUCKENBERG: You can't put a full 5 square foot value on that because it's two different 6 types of construction. 7 MR. RUNNER: But you end -- but you do end 8 up -- you end up with a total value and you can 9 divide it by the square footage. 10 MR. KRUCKENBERG: You do. 11 MR. RUNNER: And then that ends up -- then 12 that ended up being around 400-some-odd-dollars a 13 square foot. 14 MR. KRUCKENBERG: Right. But there's two 15 different things we're talking about here. One, 16 we're talking about building the house. 17 MR. RUNNER: Yeah. 18 MR. KRUCKENBERG: Two, we're talking about 19 what the plans say. And that's what I put my number 20 to, is a remodel and renovation. 21 MR. RUNNER: So you -- you did your plans 22 based upon the plans, not necessarily the 23 construction of the house? 24 MR. KRUCKENBERG: That's what 25 Mr. McAllister -- Mr. McAllister said he did his 26 numbers on as well -- 27 MR. RUNNER: Okay. I'm just checking. I'm 28 just checking. 94 1 MR. KRUCKENBERG: -- based on the plans. 2 MR. RUNNER: Based on the plans, not on 3 the -- not on the real values of the house. 4 MR. KRUCKENBERG: Well, if this house was 5 actually taken down to sticks and there was a new 6 foundation -- 7 MR. RUNNER: Right. 8 MR. KRUCKENBERG: -- there would be another 9 set of plans. There would be a different set of 10 permits. There would be structural engineering 11 involved. 12 MR. RUNNER: Right. 13 MR. KRUCKENBERG: None of that stuff was 14 produced. I don't see any permits outside of a 15 remodel room addition permit. 16 MR. RUNNER: So let me go back to the 17 question. Given the quality that you see in this 18 house, and I assume you've seen some of the 19 materials and you know the house then by 20 description. 21 MR. KRUCKENBERG: Description. 22 MR. RUNNER: Not by the plan but by 23 description? 24 MR. KRUCKENBERG: Correct. 25 MR. RUNNER: Would you have been able to 26 build that house for $400 a square foot? 27 MR. KRUCKENBERG: No. But I never said 28 that. 95 1 MR. RUNNER: Okay. You couldn't -- I'm 2 hearing you say you couldn't do that. 3 MR. KRUCKENBERG: Build that house? No, I 4 could not. 5 MR. RUNNER: Okay. Okay. Thank you very 6 much. 7 MR. KRUCKENBERG: Sure. 8 MR. RUNNER: Let me -- I guess the bottom 9 line for me, I guess I'll summarize where I'm at. 10 And that is I find -- I find the FTB's numbers to 11 not be very believable. Somehow I feel like they 12 were trying to target a number and trying to get 13 there in whatever way they could. And so that 14 troubles me in this particular issue. 15 And it -- and the frustration for me is 16 then it brings us to this idea of us determining 17 value. And, quite frankly, I don't know how to do 18 that. I don't -- I don't know what this stuff is. 19 I don't know how much some of the finish is. 20 And so it really seems to me that, I guess 21 as I look at my role here, if the government can't 22 bring its argument in a credible way to which at 23 least I'm having struggles with right now, then it 24 seems to me I have trouble figuring out what I would 25 believe the number would be and would lead me have 26 to then believe what the taxpayer said. Because I 27 must tell you, I find the taxpayers' witnesses much 28 more compelling in regards to both experience and 96 1 what it is that they were there. And then actually 2 their involvement during the construction process. 3 So I guess that's where I find myself right 4 now. 5 MR. HORTON: Member Stowers. 6 MS. STOWERS: Thank you. I have questions 7 of both parties. 8 But before I start, to Appeals. 9 MR. AMBROSE: Mm-hmm. 10 MS. STOWERS: I believe the Appellant's 11 representative cited IRC Section 189. 12 MR. AMBROSE: Yeah, that's been repealed. 13 MS. STOWERS: I'm unable to retrieve it. 14 Can you -- 15 MR. AMBROSE: I looked it up. It was 16 repealed in 1986. 17 MS. STOWERS: 1986? 18 MR. AMBROSE: '86. 19 MR. BERNSLEY: Replaced with two -- 20 263(a). 21 MR. AMBROSE: Okay. I'll look that one up. 22 MS. STOWERS: Would you look that up, too, 23 and let me know what it says and how it applies to 24 the tax years that the Appellants constructed their 25 property? And then we'll come back to you in a 26 minute. 27 MR. BERNSLEY: Do you want me to address 28 that? 97 1 MS. STOWERS: No. I want Appeals to 2 address it. 3 MR. BERNSLEY: Okay. 4 MS. STOWERS: Thank you. 5 MR. BERNSLEY: Sure. 6 MS. STOWERS: Okay. Where do I start? 7 It's 12:00 o'clock. 8 Franchise Tax Board first. I believe, in 9 your October 29th, '15 supplemental, supplemental 10 briefing, you indicated that you were willing to 11 consider a construction cost per square footage of 12 488 adjusted. 13 MS. WOODRUFF: Right. 14 MS. STOWERS: And then reduce it to 436 15 based on the appropriate index. 16 What are you viewing as the appropriate 17 index, and how did you get to the 488? 18 MS. WOODRUFF: Okay. First, I just want to 19 note that the 488 was a calculation error. So what 20 that was supposed to indicate was the average price 21 per square foot of the five sample properties that 22 Mr. Williams provided to us at the last hearing. 23 MS. STOWERS: Okay. 24 MS. WOODRUFF: I went back and looked at 25 that and had an FTB auditor look at it with me, and 26 we concluded that the average square foot price was 27 $600. And, yes, we are willing to consider that. 28 Now, the appropriate discount factor, we 98 1 determined, after consulting with an FTB economist, 2 was -- would be either the building cost index or 3 the construction cost index. And those indexes 4 reflect the changes in construction costs over time 5 in the Los Angeles area. 6 So we believe that that index is a little 7 bit more appropriate here rather than just national 8 housing cost index as Appellants have -- have used. 9 And, I'm sorry. What was the second part 10 of that question? 11 MS. STOWERS: So you're telling me that 12 it's actually 488? 13 MS. WOODRUFF: Right. 14 MS. STOWERS: The average from those five 15 comparables that we did receive. And using one of 16 these indexes, do you -- are you at 436 -- 17 MS. WOODRUFF: Right. 18 MS. STOWERS: -- or are you at a different 19 number? 20 MS. WOODRUFF: I'm sorry. We're at 436 -- 21 MS. STOWERS: You're at 436 when -- 22 MS. WOODRUFF: -- using one of the 23 indexes. 24 MS. STOWERS: And you're using your index 25 and you're using a 1999 -- 26 MS. WOODRUFF: Right. 27 MS. STOWERS: -- fancy-dancy number. 28 MS. WOODRUFF: That's right. 99 1 Ms. STOWERS: And there's a dispute on 2 whether or not we're at 1999 or we're at 2001. 3 Okay. Just wanted to get clear on where we 4 were at if we index it all, if we use a square 5 footage. 6 So we have five comparable properties. 7 Well, Mr. Williams, you -- I'm a little confused now 8 because I thought the eight comparables that was 9 referenced in your Exhibit D of your report, which 10 is Appellants' Exhibit 7 in our handouts today. If 11 you go to Exhibit 7 and then go to Exhibit D, you 12 list those seven properties -- eight properties, 13 excuse me. 14 I thought you used those eight properties 15 to get to your most likely cost of 9 million. But 16 did I understand you today that you did not use 17 those eight properties? 18 MR. WILLIAMS: Yeah, I -- I -- I didn't use 19 all eight simply because two -- two out of the eight 20 was not available. I couldn't find the data, okay, 21 within my database. 22 MS. STOWERS: So you didn't use them. But 23 did you use them in 2011 -- 24 MR. WILLIAMS: But they -- 25 MS. STOWERS: -- when you did your 26 estimate? 27 MR. WILLIAMS: Yeah. When I did my 28 estimate, I used the comparables as far as location 100 1 is concerned, not so much as cost per square foot. 2 I made -- I made adjustments on the six that I 3 submitted to you, okay. And I did those on a basis 4 of adjustments for swimming pools; some of 'em had 5 swimming pools, some of 'em did not. Okay. Some of 6 had extensive landscaping; some did and some did 7 not. Okay. Some were spec properties where there 8 were -- the owners were speculators. Okay. They 9 bought the land and built the property on a 10 speculation basis. Some were -- some were 11 owner-builders and the whole bit. 12 So that is the difference between the 13 overall square -- per square foot. 14 Some of the adjustments I made was 15 concerning the high-end versus the -- I would say 16 the average home in Montecito. 17 MS. STOWERS: Okay. 18 MR. WILLIAMS: Okay. 19 MS. STOWERS: When you say you made 20 adjustments, are -- do we see the adjustments in 21 your actual report, or is that someplace else? 22 'Cause when I read the report, I just get to the -- 23 the bottom number. 24 MR. WILLIAMS: Okay. 25 MS. STOWERS: And then when I received 26 your -- the five comparables that you were able to 27 obtain, I'm still having a hard time how you got to 28 the -- to your estimate number. I mean I had asked 101 1 for, "Show me where in the record you made the 2 adjustments," and to this date I'm looking for some 3 kind of a schedule showing that property one was X 4 amount and then you adjusted it up and down based on 5 what you think were the differences in the 6 properties, and I'm not seeing it. 7 MR. WILLIAMS: Okay. 8 MS. STOWERS: Am I -- am I not going to see 9 that? Is that -- am I misunderstanding how you did 10 your report? 11 MR. WILLIAMS: No, no. That is something 12 that you can have. I mean, but the thing -- the 13 thing is that the bottom line is that the cost per 14 square foot that I gave in my report, okay, was -- 15 was based on my expertise on the square footage, the 16 plan and permits that were obtained, and my review 17 and -- and conversations with the appraisers and the 18 local contractors. 19 MS. STOWERS: Okay. I understand. 20 MR. WILLIAMS: Okay. So -- 21 MS. STOWERS: So -- 22 MR. WILLIAMS: So -- so the bulk of my 23 report was based on those items I just mentioned, 24 not the comparables. 25 MS. STOWERS: Not the comparables. 26 So, I understand that. And maybe I 27 misunderstood what that report represented, but I 28 would take that into consideration. 102 1 But I do want to focus on the comparables 2 that we did receive. And I don't want to disclose 3 anybody's address, so I'm going to try to -- if you 4 go to Mr. Williams' Exhibit D and you go to the 5 comparable, which I believe is number 4, street 6 address starting with 700. It has a total project 7 cost of 17.8 million and a total building cost of 8 8.3. 9 MR. WILLIAMS: Yeah. Okay. 10 MS. STOWERS: My fist question with respect 11 to that, and I guess with all of those -- and we 12 know, at least on the report, we have a loan 13 analysis dated 2007. So for that particular 14 property, do you know if it was built in 2007 or if 15 it was built at some time thereafter? 16 MR. WILLIAMS: If the documents show 17 "2007," that means the loan was in progress. 18 MS. STOWERS: The loan was -- 19 MR. WILLIAMS: It was in -- it was in 20 progress, okay -- 21 MS. STOWERS: Okay. 22 MR. WILLIAMS: -- in 2007. Okay. 23 MS. STOWERS: So the loan -- 24 MR. WILLIAMS: And you're talking about the 25 XXX XXXXXXX XXXX, right? 26 (By agreement, a portion of the transcript 27 was redacted to protect the identity of the 28 parties.) 103 1 MS. STOWERS: Yeah. I was trying not to do 2 an address. 3 MR. WILLIAMS: Well, yeah. 4 MS. STOWERS: But that's exactly what I'm 5 talking about. 6 MR. WILLIAMS: Okay. 7 MS. STOWERS: So the loan was in progress 8 in July 2007. 9 MR. WILLIAMS: Yeah. 10 MS. STOWERS: But -- and construction 11 was -- I'm going to make the assumption -- had 12 started. But is it reasonable to conclude that 13 construction was not completed at the end of 2007? 14 MR. WILLIAMS: Well, the documentation that 15 I gave you, that indicated exactly what stage the 16 construction was in. 17 MS. STOWERS: Well, the documentation that 18 you gave me, I have a loan analysis package with a 19 lot of redacted dates, although I asked for my dates 20 not to be redacted on the August Board Member 21 inquiry. 22 MR. WILLIAMS: Okay. 23 MR. WILLIAMS: But -- 24 MS. STOWERS: -- when he submitted his 25 application. So -- 26 MR. WILLIAMS: But it also indicates the 27 dollar amount that's requested. 28 MS. STOWERS: Yeah, but my question is -- 104 1 I'm more trying to get to -- 2 MR. WILLIAMS: Mm-hmm. 3 MS. STOWERS: -- when was this project 4 completed? 5 MR. WILLIAMS: Okay. 6 MS. STOWERS: Not the dollar amount. So, 7 okay, are you in a position to say when it was 8 completed? 9 MR. WILLIAMS: Well, no, I'm not. 10 MS. STOWERS: Okay. Okay, that's fair. 11 MR. WILLIAMS: Yeah, I -- I -- I couldn't 12 tell you. 13 MS. STOWERS: When I go back to the actual 14 calls -- let me go back to my notes. 15 MR. WILLIAMS: Okay. If you go back to 16 that document, okay. 17 MS. STOWERS: Mm-hmm. 18 MR. WILLIAMS: Okay, the disbursement 19 request by the general contractor and/or owner, 20 okay, does it give a date? 21 MS. STOWERS: No, it's redacted. 22 MR. WILLIAMS: Okay. Does it give a 23 percent complete? 24 MS. STOWERS: It says original project is 25 69 percent complete. 26 MR. HORTON: Pardon me. 27 Ms. Stowers. 28 MS. STOWERS: Okay. I mean I -- I -- I 105 1 don't know. I mean I asked, but everything was 2 redacted twice. 3 MR. HORTON: Well -- 4 MS. STOWERS: That's okay. I'm okay with 5 that. I under -- I respect that you may not know 6 and for -- 7 MR. WILLIAMS: Right, sure. 8 MS. STOWERS: -- privacy reasons you 9 redacted it and I respect that you wanted to -- 10 MS. HARKEY: 69 percent. 11 MR. WILLIAMS: Okay. 12 MS. STOWERS: Okay. So I'm good with that. 13 I just want to understand the numbers that I'm 14 looking at. 15 MR. WILLIAMS: Mm-hmm. 16 MS. STOWERS: And so when I look at the 17 numbers, if I -- on that one particular project, 18 it's 7.8 million in project costs. So, am I correct 19 this is what we're -- the cost for this particular 20 owner to construct their property, whether it was 21 new or remodeled? 22 MR. WILLIAMS: Yes. 23 MS. STOWERS: Okay. 24 MR. WILLIAMS: The $7.8 million represents 25 the loan and any soft costs related to that 26 particular project. 27 MS. STOWERS: Okay. 28 MR. WILLIAMS: Okay. It does not include 106 1 monies that were paid prior to recordation of the 2 first trust deed or monies spent after. Okay. 3 So, the $700,000 -- $7 million is a cost 4 based on loan amount. 5 MS. STOWERS: Gotcha. 6 MR. WILLIAMS: Not cost. 7 MS. STOWERS: Not actual -- whatever the 8 owners actually paid. 9 MR. WILLIAMS: Spent. 10 MS. STOWERS: Okay. 11 MR. WILLIAMS: Okay. 12 MS. STOWERS: Perfect. 13 FTB, did you use that 17.8 million when you 14 got to your, um -- your average costs per square 15 foot? 16 MS. WOODRUFF: Yes, I believe we did -- we 17 did. 18 MS. STOWERS: Okay. I'm just trying to 19 make sure that everybody's on the same page. Or if 20 this Board was to look at square footage, we -- we 21 got some numbers here. 22 MR. McALLISTER: Yes. 23 MS. STOWERS: And then I guess do you -- do 24 you have any experience with this property? Do you 25 have any idea when it was completed? 26 MR. McALLISTER: 2009-and-a-half. 27 MS. STOWERS: 2009-and-a-half. 28 2009-and-a-half? 107 1 MR. McALLISTER: Exactly. In June. 2 MS. STOWERS: Okay. 3 MS. HARKEY: Pretty accurate. 4 MS. STOWERS: And so for that particular 5 property, it's about 1300 per square foot -- 6 MR. McALLISTER: Yes. 7 MS. STOWERS: -- to complete. 8 MR. McALLISTER: And that's for a property 9 that, you know, the landscaping, it looks like, you 10 know, a golf course. It's -- it's magnificent. 11 MS. STOWERS: Do you think it's comparable 12 to the property, the Garden Lane property? 13 MR. McALLISTER: Yes, extremely similar. 14 MS. STOWERS: Great, thank you. 15 And -- and then to the Appellants -- and 16 let me know if my research is wrong -- but I did a 17 public research check and it indicates that you guys 18 were the owner of that property; is that accurate? 19 MS. BERKOFF-LOWE: That's correct. 20 MS. STOWERS: Okay. 21 MS. BERKOFF-LOWE: That's where we're 22 living. 23 MS. STOWERS: That's where you guys are 24 currently living. 25 Okay. Reproduction costs. I'm looking 26 at -- and this is to the Franchise Tax Board. I'm 27 looking at the Harding's 2003 appraisal. And I 28 realize that Mr. Harding did a declaration saying 108 1 that he's not a construction expert. But he did 2 come up with a reproduction cost of 5.2 million. 3 Did you guys consider -- is that the same 4 reproduction cost that Mr. Kruckenberg looked at and 5 made adjustments to? 6 MS. WOODRUFF: That's correct. 7 MS. STOWERS: And he made downward 8 adjustments? 9 MS. WOODRUFF: He made downward adjustments 10 based on the date of the appraisal -- so it was a 11 couple years after the work was completed -- and 12 also based on the fact that the -- the -- the 13 reproduction costs considered a brand new build, 14 kind of from the ground up, which is not what we had 15 here. 16 MS. STOWERS: Okay. Did you guys consider 17 the site improvements of 760,000? 18 MS. WOODRUFF: Sure. Well, one was the 19 attestation, Mr. Nulty's attestation. 20 MS. STOWERS: Mm-hmm. 21 MS. WOODRUFF: And the next part -- the 22 next place that I saw it was in Mr. Williams' 23 report; and I believe it was page 10. 24 MS. STOWERS: What's the amount? I guess 25 you could just help me out a little bit more. 26 MS. WOODRUFF: Sure. Under "other costs, 27 professional fees, architectural and engineering" it 28 says 358,638 and 75 cents. 109 1 MS. STOWERS: Okay. And design fees, is 2 that a combined number? 3 MS. WOODRUFF: It's a combined number, 4 architectural and engineering. 5 MS. STOWERS: Okay. On Mr. -- 6 Mr. Bernsley, you provided an estimate 7 starting with Mr. McAllister's number. 8 MR. BERNSLEY: Yes. 9 MS. STOWERS: Give me the exhibit number. 10 MR. BERNSLEY: My analysis is Exhibit 9. 11 MS. STOWERS: Thank you. 12 Okay. Um, where are you getting the 13 interior design fees of 870,000? How are you 14 getting to that number? 15 MR. BERNSLEY: That was from Kyle Irwin's 16 declaration, which is Exhibit 10. 17 MS. STOWERS: So that's based on his 18 declaration where he said had he been the main 19 designer for the project, he would have charged 20 about 960 to 720 at one phase and then gone to an 21 hourly rate for the second phase. 22 MR. BERNSLEY: That's correct, because 23 that's the -- the basis of this analysis is to take 24 what the estimate is of what it would cost to build 25 today, using all of today's numbers and today's 26 people, and then discount that back. 27 Now, it's interesting that we didn't know 28 prior to this, or I didn't know prior to this, but 110 1 Mr. Irwin also indicated that he had done work on 2 Garden Lane. And the significance of that, again, 3 is that when you look at the line items for the 4 documentation that was available, the only designer 5 that was revealed in the documentation was 6 Lafia/Arvin. So the conclusion was that whatever 7 paid -- was paid for Lafia/Arvin, assuming we could 8 peg that number, that that was the design fee. 9 But clearly that's not the case because we 10 now know that Mr. Irwin was another designer that 11 provided services and design services and we didn't 12 even know about that. And -- and so that's one of 13 the difficulties with this case, is that when you 14 have a number, there's no way to know how much that 15 number represents of even that category. 16 MS. STOWERS: That's where it came from, 17 okay. I had a hard time following it, but I think I 18 understand because I did do a quick math and it 19 looks like it's -- the numbers that he provided of 20 what his range, the average of those two numbers 21 plus 30,000 for what he indicated he actually 22 charged the Lowes for his designing service during 23 that time. 24 MR. BERNSLEY: Something along those lines. 25 I don't recall exactly, but that's where it came 26 from. 27 MS. STOWERS: Right. 28 (Inaudible.) 111 1 I was just struggling with that number. 2 But I understand that's not -- you're not 3 saying that's a verifiable design fee number. 4 That's just one of your ways of -- 5 MR. BERNSLEY: That was -- that was 6 actually spent on Garden Lane? 7 MS. STOWERS: Yeah. You're not saying that 8 at all. 9 MR. BERNSLEY: No, we have no idea. 10 MS. STOWERS: We have no idea of how much 11 was spent because we have the missing records. 12 MR. BERNSLEY: That's right. And one of 13 the -- one of the things about a construction 14 project is when you -- when you make a budget, you 15 know, you have however many line items. It could 16 be, I don't known, 50, 60. These guys -- the 17 experts can tell you how many line items could 18 possibly be there. 19 So you have a budget of what -- what you 20 think is going to be spent. But the reality is that 21 when it's all said and done, this number might be 22 higher, this number might be lower. Money's moved 23 from here to there. So what is actually spent at 24 the end of the day can look entirely different from 25 what's budgeted at the beginning of the project. 26 MS. STOWERS: Okay. 27 MR. BERNSLEY: So when -- when you look at 28 any given line item and say, oh, in reality this 112 1 number was actually lower, that may be true, but a 2 different number could be higher. 3 So, to -- to reduce the bottom line total 4 based on a single line item is to assume that every 5 other line item on the list is absolutely accurate, 6 which is an absurd and unrealistic assumption. So, 7 you know, you can't really look at it on a line item 8 basis. 9 MS. STOWERS: I understand that. 10 To our experts, Mr. McAllister, when -- 11 when it -- help me out in your business. When you 12 do do a budget and you're seeing that it's going to 13 cost more, do you go back to your client and say, 14 rebudget 5 million; it's now looking like -- 15 whatever the number may be? And do they have to 16 sign off or is it -- 17 MR. McALLISTER: Yes. 18 MS. STOWERS: That's what I thought. 19 MR. McALLISTER: Yeah, you gotta -- you 20 just don't keep running along like you're the bank 21 and, you know, the builder's the bank and we'll just 22 figure it out at the end. Every step is -- you 23 know, we talk about it and, you know, of course we 24 talk about price and keeping budgets under control. 25 And invariably they -- they always run high. It's 26 just they -- they do. 27 Some of it's unexpected and some of it is 28 homeowner want, you know. And it's usually about 113 1 50/50 there with, you know, what -- why things 2 increase. 3 MS. STOWERS: Why they increase. 4 MR. McALLISTER: But it's usually what the 5 homeowner wants. 6 MS. STOWERS: Yeah. So then, Mrs. Lowe, I 7 have a couple of documents, and this is probably why 8 FTB is struggling with the numbers. We have the 9 budget report from your actual contractor Mr. Sweet. 10 And he initially budgeted like 1.7 which was -- and 11 he even said in that budget it's going to be -- 12 it's, uh -- the budget is low. So I think he 13 recognized in 1997 that what he was estimating was 14 not going to be true. 15 And then I have a letter from the bank 16 dated June of 1998 when they are telling Mr. Harding 17 to go back out and appraise the property, and 18 basically says that there's been substantial changes 19 and -- let me make sure I quote 'em right. 20 So did you -- 21 MS. STOWERS: Right. 22 MS. BERKOFF-LOWE: -- to when we actually 23 sold the house. 24 MS. STOWERS: Right. 25 I would say, me, when I lived in that 26 house, I knew when I moved in I still had a lot of 27 work to do. And, um -- and then as I lived there, 28 certain things I wanted and desired, I -- I did. 114 1 And some of it I did without my contractor and some 2 of it I did with him. 3 MS. STOWERS: So that's what I was going to 4 ask you. Did your contractor say you are exceeding 5 what we budget? But you're telling me is that you 6 just -- you knew what you wanted and you just, 7 you -- 8 MS. BERKOFF-LOWE: My contractor knew, 9 definitely, probably, not to say that -- 10 MS. STOWERS: Okay. 11 MS. BERKOFF-LOWE: -- to me. He would be, 12 like -- 13 MS. STOWERS: Okay. 14 MS. BERKOFF-LOWE: -- in big trouble. 15 MS. STOWERS: Um -- 16 MR. McALLISTER: I'm -- I'm still there, 17 five years later, on the house that she's in now. 18 MS. BERKOFF-LOWE: I was going to make a 19 joke about that and I thought I probably shouldn't, 20 but -- 21 MR. McALLISTER: You know, there's things 22 all the time. 23 MS. BERKOFF-LOWE: I just called Matt and 24 said, "I want to build onto the closet." And he was 25 like, "I'm hanging up on you." 26 MS. STOWERS: Okay. 27 Appeals, any luck on those statutes for me? 28 MR. AMBROSE: Yeah. I don't think it 115 1 applies here, 263(a). The title is "Capitalization 2 and Inclusion in Inventory Cost of Certain 3 Expenses." And it says that it applies to property 4 produced by the taxpayer or acquired for resale. 5 Real or tangible personal property produced by the 6 taxpayer. 7 However, there is an exception. For 8 personal use property, it says, the section shall 9 not apply to any property produced by the taxpayer 10 for use by the taxpayer other than in a trade or 11 business or an activity conducted for profit. 12 So, I don't think that has any application 13 here. 14 MR. BERNSLEY: Right. And that -- and that 15 is a deduction disallowance section. It is not a -- 16 it is not a capitalization disallowance section. 17 MS. STOWERS: Okay. Okay. Thirty minutes; 18 not bad. 19 Where am I? I mean I agree, we have a lot 20 of data here. It's a very difficult case. 21 Unfortunately, I know FTB won't speak to settlement. 22 That's not -- that's not within these attorneys' 23 purviews. But, unfortunately, they're in agreement 24 that the parties could not come to an agreement. 25 Oh, before I go there, Cohan Rule, what 26 does the Cohan Rule tell us, Appeals, as far as 27 applying estimates? 28 MR. AMBROSE: Well, Cohan just basically 116 1 says that if there's evidence that there were 2 expenses incurred, then -- and then there is no 3 original documentation, you take -- you make an 4 estimate based on the best available evidence. And 5 if -- if there's any doubt if it's -- you know, if 6 it's questionable, then you, you know, that question 7 is basically against the taxpayer. You know, you 8 don't -- you don't give them the benefit of the 9 doubt in other words; the taxpayer, that is. 10 MS. STOWERS: Weigh heavily against the 11 taxpayer? 12 MR. AMBROSE: Weigh heavily against the 13 taxpayer, correct. 14 MR. BERNSLEY: May I speak to that? 15 Because I think the cases say -- excuse me -- it's 16 weighed heavily against the party that caused the 17 loss; which, in many cases, is in fact the taxpayer, 18 but it doesn't have to be. 19 And in this case the Lowes did not cause 20 the loss. They were a victim of this just like the 21 system was. And their actions fell below no 22 standard of duty, no standard of care. They didn't 23 lose the documents. There was nothing they did to 24 cause the loss of the documents. And there is 25 nothing they could have done to prevent the loss of 26 documents. In fact, they did everything that was 27 entirely reasonable that they could do under these 28 circumstances. 117 1 So -- 2 MS. STOWERS: Okay. I understand. 3 My final question to Appeals. The letter 4 that was provided to Ms. Ma regarding the -- the 5 assessed value of the land and assessed value of the 6 improvement for the 2005 sale, how does that relate 7 to cause to construct in 1999 through 2003? 8 MR. AMBROSE: I don't think it does relate 9 to it. It's the fair market. It's -- I'm sure 10 that's the sale price. And that's based on fair 11 market value, which is, as you know we heard today 12 many times, it's an entirely different number than 13 the adjusted basis, which is based on cost of 14 construction and, you know, associated costs. 15 So -- I mean it might be some kind of a 16 guide. But, you know, for purposes of this appeal, 17 I don't think that it's really a very reliable 18 indicator. 19 MS. STOWERS: Okay. 20 MS. HARKEY: May I weigh in on that? 21 MR. HORTON: Member Harkey. 22 MS. HARKEY: I'd -- I'd like to weigh in on 23 that. 24 Usually -- usually when you've got this 25 much of a discrepancy, it is the value of the land 26 that has increased, and especially in southern 27 California. The fair market of the land usually 28 goes up. The cost of construction is pretty much 118 1 fixed, you know. It's -- so I would -- I would beg 2 to differ there. 3 MS. MA: I agree. 4 MR. HORTON: Okay. 5 MS. STOWERS: Okay. I -- I -- I think I'm 6 finished. I think we're at the point where we're 7 just going to have to apply a reasonable estimate. 8 MR. HORTON: Okay. 9 First, to Appeals, thank you very much for 10 the clarification of the law as it relates to 11 noncapital expenses. 12 The Board is placed in a -- at a serious 13 disadvantage here of having to use our past 14 experiences to come up with values. And to, uh -- 15 but it is -- it is where we are and we find 16 ourselves. The reality is experts will always 17 agree. 18 MR. RUNNER: No. 19 MR. HORTON: Since you guys didn't bust out 20 into laughter, so you didn't really get the joke 21 there. 22 MR. RUNNER: Holding my breath. 23 MR. HORTON: All of these experts sort of 24 disagree for the various different reasons and I get 25 that. And, I mean, part of me kind of wants to go 26 through these different estimates and so forth and 27 speak to what I find the credibility of it. 28 In the Williams' estimate, the calculation 119 1 was based on the actual plans and much of what 2 wasn't finalized by the time he saw the -- saw the 3 property and made his estimate. Therefore, his 4 estimate would be flawed. 5 The estimate provided by the FTB is just -- 6 just unreasonable relative to just the plain sight 7 of what happened here. And so that in and of itself 8 says to me that the Cohan Rule is applicable and is 9 the only direction that we can -- one of the 10 directions that we can go in trying to determine 11 what this -- what the actual cost was. 12 To the appraisal that we received, it is 13 informative to me, but it's not directive to me in 14 that the land value has increased almost 500 15 percent. 16 I agree with Member Harkey that the actual 17 cost doesn't change, but the appreciated value will 18 change relative to the time that the cost occurred. 19 And so having a $13 million allocation to 20 the ultimate market price, if you recalculated that, 21 that would take you down to even a lower number as 22 far as the costs relative to what the FTB is 23 claiming or the Lowes are claiming. So I don't find 24 that useful in -- in making this assessment. 25 And so, um -- so we're -- we're somewhat in 26 a catch-22. The Harding appraisal, his disclaimer, 27 I think, is normal. I mean the estimated amount 28 that he provided was actually somewhere between 120 1 2 million and 5 million because of that disclaimer 2 when they go in and they basically say, "Listen, I 3 didn't build this thing. I'm just an appraiser. 4 I'm just out here on behalf of the lender to tell 5 you what I think the value is at the point in time 6 that I'm here." 7 The other challenge that I -- that I think 8 we're faced with here is the -- it appears that the 9 FTB's number of $4 million is just too low. And so 10 we're in a catch-22 in that regard, and for a number 11 of reasons. The value seems to be established in 12 1999. I think the Lowes' testimony is credible in 13 that they continue to do -- continue to do 14 improvements to this property and therein is where 15 we have the challenge. 16 This is the individual that I presume 17 prepared the return. So he can't justify the 18 returns himself and he prepared the returns. So, 19 again, putting us at a -- even more of a 20 disadvantage. 21 The other direction that -- that I'm 22 mindful of is to -- in taking a look at the actual 23 evidence that was provided, that we could see, 24 clearly the accountant had made a number of errors 25 in their calculations. They had actually claimed 26 expenses that were not -- that you couldn't claim, 27 that you couldn't capitalize. 28 So there were a number of expenses in there 121 1 that should not have been capitalized, which is 2 indicative that the accountant made an error in 3 capitalizing expenses. So the number on the return 4 is wrong based on the fact that he made mistakes in 5 capitalizing expenses. 6 Which takes us to the discussion about 7 whether noncapitalized interest should be -- can be 8 included and deducted. I don't think it can. I 9 mean I don't -- based on my read of the law, that it 10 shouldn't be deducted. 11 I mean I agree with Appeals, our lawyer, 12 that it's not deductible. And, thereof, if I was 13 just simply to take the $13 million claimed and 14 subtract the land value of 2 million, then subtract 15 the 2 million noncapitalized expenses, and then 16 adjust for the error in just reporting errors of 17 claiming expenses -- which no fault of anyone here 18 today, certainly not the Lowes -- adjusting for the 19 expenses, it still takes you down to -- takes me 20 down, in my calculations, to somewhere around 21 $7 million is where we would -- you know, I would 22 be. 23 I would have a real problem in allowing the 24 full amount on the tax returns because there's 25 clearer evidence -- not speculation, not estimates, 26 not appraised values -- there's just clear evidence 27 that there is -- there was an error. There was an 28 error in computing; it included draperies, it 122 1 included security, security monitoring expenses and 2 so forth. 3 I -- but I don't want to sit here and kind 4 of go over the errors that the accountant made, you 5 know what I mean. I don't want to go through all of 6 that. And unless there is -- I'm going to -- I had 7 a -- 8 MR. BERNSLEY: May I be heard? 9 MR. HORTON: -- had a meeting -- excuse me. 10 I had a meeting, but I'm going to go back 11 and review this law as it relates to the 12 noncapitalized expenses and -- but I don't -- I 13 just -- I've been researching it, and I just can't 14 find any means -- any body of law that would allow 15 you to have deducted those noncapitalized expenses 16 to the tune of 2 million. 17 (Bell ringing.) 18 MR. HORTON: Saved by the bell. 19 But you wanted to -- to share some 20 thoughts. 21 MR. BERNSLEY: Yes, you made a couple of 22 statements that I don't think are accurate. 23 There were documents that were provided to 24 the FTB that had items disclosed, but there was -- 25 that -- that would not be capitalizable. But 26 there's no evidence that those were included in 27 basis. 28 In addition, I agree that certain interest 123 1 is not deductible; that's a very different issue of 2 whether interest should be capitalized. 3 The current deduction of interest, there -- 4 there are several sections in the Internal Revenue 5 Code that restrict the current deduction of 6 interest. None of those sections address the 7 capitalization of interest. The only section that's 8 been around a long time is 266 that goes back to 9 the -- at least to the beginning of the 1954 code 10 that addressed the tension between deducting 11 interest and capitalizing interest, and essentially 12 said you can't deduct interest if you capitalize it. 13 It, as well as Regulation 1016-2(A), 14 coordinate with each other. One says if you deduct 15 it, you can't capitalize it. The other says if 16 you're deducting it -- 17 MR. HORTON: Okay. So, I'd like to -- 18 to -- to give the Board's lawyers a chance to kind 19 of review that and figure it out and come back and 20 tell us what their conclusion is in that regard. 21 The challenge is, is that you're 22 disagreeing with what your accountant -- it's the 23 accountant that provided these -- or someone 24 provided these schedules -- 25 MR. BERNSLEY: Well, he did, but-- 26 But, so we've got these conflicting 27 arguments within the experts -- the accountant, 28 you're in conflict with them, now in conflict with 124 1 Appeals. 2 Appeals -- 3 MR. AMBROSE: If I might, Mr. Chair. 4 MR. HORTON: -- look like they're itching 5 to say something. 6 MR. AMBROSE: Yeah. I don't know that I 7 disagree with Mr. Bernsley. I was just, you know, 8 stating the law. He brought up 189 and, you know, 9 we looked it up and it didn't -- or it's repealed. 10 MS. HARKEY: That's right. 11 MR. AMBROSE: We don't know the numbers. I 12 believe it's in the protest hearing officer's 13 report. But I don't -- you know, I don't have at my 14 disposal right now the numbers that they were -- you 15 know, the interest amounts that they were claiming 16 and whether they had already deducted those. I just 17 don't have that information. 18 MR. HORTON: Well, let's see if we can -- 19 MR. AMBROSE: I'd certainly be able, you 20 know, if we can get that. 21 MR. HORTON: Yeah, let's see if we can get 22 it so you can take a look at it. That would be, I 23 think, helpful to all parties here. 24 Member Harkey. 25 MS. HARKEY: I think more to the point is 26 that we've got a lot of estimates. We have a lot of 27 estimates and we know that the FTB's is not 28 accurate. 125 1 So I'm tending to -- I'm tending to go 2 along with the taxpayer in this case because Szabo, 3 even though he submitted documents, he did not have 4 all the documents. These were the best he could 5 contrive. 6 So you can't really say that everything on 7 there was actually factual. You can't say that 8 everything that was submitted by this gentleman was 9 actually factual. They all are trying to 10 extrapolate something that they didn't have, which 11 is why we're here on Cohan. 12 And as for the land and improvements value 13 on the assessor, even if you discount back the 13 14 to -- because the assessor increased it by two -- 15 would increase everything by two percent, per year, 16 from whenever this was completed. And if I discount 17 it back by -- if I discount it back by five years, 18 I'm still only -- I'm still only deducting a million 19 from a $13 million cost. And they were paying taxes 20 on 13 million. They were paying the taxes. 21 So, I guess I'm having a real hard time 22 going back to 7 million because we all know, just 23 looking at this, this book, that's more than 24 7 million. 25 And I think the capitalized interest is one 26 thing we'll have to look at. But they were paying 27 taxes. They were paying property taxes on the 13 28 million when they sold it -- on 13 million of 126 1 improvements. So discounting that back to whenever, 2 even if you go back to 1999, you're going to come up 3 with more than a $7 million improvement cost. And I 4 know that you're not supposed to be using -- using, 5 you know, sales price and whatnot, but if in fact 6 you're taxing improvements, that's improvements. 7 The rest of it's attributable to the land. 8 MR. HORTON: Yeah. 9 MS. HARKEY: That's cost of improvements. 10 MR. HORTON: This is the -- you know, as I 11 do these calculations in my head, I don't know that 12 we're all that far apart. But the -- the appraised 13 value is the allocation of the selling price. And 14 adjusting the selling price back 2 percent would get 15 you to what the selling price theoretically would 16 have been at that point that you make the 17 adjustment. Which, one would presume would be a 18 relative markup on that. 19 And so what I was basically saying is that 20 the markup on the land was almost 500 percent. And 21 so to calculate that, you would presume that 22 there's a -- there's an increased value from the 23 cost. I mean, even if you -- if you built it today 24 and turned around and sold it tomorrow, you're going 25 to sell it for -- there's going to be a markup on 26 the cost. 27 And so the -- the million-dollar adjustment 28 in the selling price, using the 2 percent ratio, 127 1 would take us back to the selling price but not 2 necessarily the cost. 3 My -- my apologies, sir. That was just a 4 statement. 5 Member Ma. 6 MS. MA: So I -- I would -- 7 Is my mic on? 8 MR. RUNNER: Mm-hmm. 9 MS. HARKEY: It was. 10 MS. MA: My mic on? Yeah. 11 So I -- I would just like to piggyback on 12 Ms. Harkey. 13 I'm looking at your 2005 tax returns. You 14 had an extension granted to October 16th of 2006. 15 Your CPA signed the tax return on 10/12/06, within 16 the extension time. I'm looking at all the numbers. 17 There's no, like, estimate or just number thrown in. 18 And so I assume when he did the sale of your home 19 calculation, that the basis that he put down was 20 based on some number that your business manager gave 21 to your CPA to put on the tax return, to file your 22 tax return. 23 So, I'm just, you know, echoing Ms. 24 Harkey's statement that, you know, given -- you 25 know, it's hard to recreate documents 10 years 26 later. You know, your tax return was filed on time. 27 The numbers do seem credible. The IRS did not audit 28 your tax return. And based on, you know, the -- 128 1 the, uh -- the consultants that we have, the people 2 who, you know, have been building in the area, the 3 assessor's letter, in my opinion, you know, just, 4 you know, leads me to a comfort level that, you 5 know, you did provide the right numbers to your 6 accountants. You signed your return under penalties 7 of perjury. And that you have been good, upstanding 8 citizens, paying taxes since you were 15 years old, 9 not being late. 10 We did check in with the Franchise Tax 11 Board to see if you had any, you know -- 12 MS. HARKEY: Penalties. 13 MS. MA: -- other issues over the years. 14 And so, you know, I'm actually comfortable with the 15 numbers that were on your tax return. 16 MR. HORTON: Okay. Just a point of 17 clarification, if I may, Members. 18 The $7 million that I came up by adjusting 19 the noncapitalized interest, plus the presumed 20 errors, if you add back the land value, the number's 21 at somewhere around 10 point -- 10.8 million as far 22 as the deductible amounts. 23 This is what I meant by -- if you take 24 these various different calculations that we're 25 making here, we all seem to come in right around 26 those numbers. But I certainly appreciate my 27 colleagues' view in this -- in that regard. 28 I'm going to go to the Department on 129 1 noncapitalized interest. I've heard from everyone 2 else. 3 Your thoughts? 4 MS. WOODRUFF: Yeah. My thoughts are 5 that -- well, certainly we know that mortgage 6 interest may not be capitalized. It's only 7 deductible because -- 8 MR. HORTON: Right. 9 MS. WOODRUFF: -- of a special provision. 10 And all we know was that at protest Mr. Szabo 11 claimed that about $2 million was mortgage and 12 construction loan interest. So he didn't separate 13 it out by construction loan or mortgage loan 14 interest. So we don't even know what part of that 15 represents construction loan interest that 16 apparently it's -- it's possible it may be 17 deductible. 18 I disagree that it is deductible. I think 19 that it should -- it would only be deductible if it 20 were associated with a trade or business, which it's 21 clearly not. It was personal construction loan 22 interest here. 23 MR. HORTON: I don't think we are afforded 24 that time, so -- 25 MS. WOODRUFF: Oh, okay. 26 MR. HORTON: All right. 27 Further discussion, Members? 28 MS. STOWERS: Move to take the matter under 130 1 submission. 2 MR. HORTON: Member Stowers moves to take 3 the matter under submission. Second by Member 4 Runner. 5 Without objection, Members, such will be 6 the order. 7 This -- 8 Thank you very much for appearing before 9 us. We truly appreciate your patience with this 10 process. It's been a long, laborious process. We 11 certainly appreciate your honesty as well in 12 bringing forth the information that you sought. 13 ---oOo--- 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 131 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, KATHLEEN SKIDGEL, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on November 17, 2015 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 1 through 44 and 86 14 through 131 constitute a complete and accurate 15 transcription of the shorthand writing. 16 17 Dated: December 9, 2015 18 19 20 ____________________________ 21 KATHLEEN SKIDGEL 22 Hearing Reporter 23 24 25 26 27 28 132 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, JULI PRICE JACKSON, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on November 17, 2015 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 45 through 85 14 constitute a complete and accurate transcription of 15 the shorthand writing. 16 17 Dated: December 9, 2015 18 19 20 ____________________________ 21 JULI PRICE JACKSON 22 Hearing Reporter 23 24 25 26 27 28 133