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officer was also aware of the initial letter from the attorney
who represented petitioners against the insurance company
containing the statement that $104,000 of the $130,000 was for
“bad faith”. Although the primary focus was the question of
punitive damages, the Appeals officer’s report also contained
some discussion of section 1033.
Following the Appeals conference, petitioners wrote to the
Appeals officer explaining, a second time, that they spent more
on repairing their residence than was received from the insurance
company. In that same letter, petitioners cited section 165 and
sections 1.165-7(a)(2)(ii) and 1.123-1, Income Tax Regs. In
response to petitioners’ letter, the Appeals officer explained
that the issue in controversy was whether any portion of the
$130,000 received represented taxable punitive damages. In that
same letter, the Appeals officer acknowledged that the cost of
repairs could be used to determine a decrease in fair market
value. The Appeals officer restated the conclusion that the
$130,000 was paid for punitive damages and that petitioners’
pleading and the insurance settlement agreement contained
statements to the effect that petitioners were seeking and/or
settling punitive damage claims.
Petitioners, in response to the Appeals officer, requested
that a notice of deficiency be issued so that the matter would be
considered by respondent’s attorneys. A notice of deficiency
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