John Erwin Smith & Janet Hanani Smith v. Commissioner ( 2014 )

PURSUANT TO INTERNAL REVENUE CODE
SECTION 7463(b),THIS OPINION MAY NOT
BE TREATED AS PRECEDENT FOR ANY
OTHER CASE.
T.C. Summary Opinion 2014-13
UNITED STATES TAX COURT
JOHN ERWIN SMITH AND JANET HANANI SMITH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14306-12S. Filed February 19, 2014.
John Erwin Smith and Janet Hanani Smith, pro sese.
Craig A. Ashford, for respondent.
SUMMARY OPINION
ARMEN, Special Trial Judge: This case was heard pursuant to the
provisions of section 7463 of the Internal Revenue Code (Code) in effect when the
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petition was filed.1 Pursuant to section 7463(b), the decision to be entered is not
reviewable by any other court, and this opinion shall not be treated as precedent
for any other case.
Respondent determined a deficiency in petitioners’ Federal income tax for
2009 of $9,673.
The sole issue for decision is whether deductions for losses claimed by
petitioners on their Schedules E, Supplemental Income and Loss, are limited by
the passive activity rules of section 469.2 We hold that they are.
Background
Some of the facts have been stipulated, and they are so found. We
incorporate by reference the parties’ stipulation of facts and accompanying
exhibits.
Petitioners resided in California at the time that the petition was filed.
Petitioner John Erwin Smith holds a master of science degree in electrical
engineering and is by profession a software engineer. Over the years he has also
1
Unless otherwise indicated, all subsequent section references are to the
Internal Revenue Code (Code) in effect for the year in issue. All Rule references
are to the Tax Court Rules of Practice and Procedure.
2
Other adjustments in the notice of deficiency are essentially mechanical in
nature and will be given effect on the basis of the outcome of the issue regarding
the passive activity losses.
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purchased a number of properties, principally single-family residences in need of
repair, which he then improves and either holds for rent or seeks to sell for a
profit.
In 2007 petitioners purchased a single-family home on Solitude Way,
Rocklin, California (Solitude Way property), which they and their five children
then occupied as their personal residence. Petitioners continued to use the
Solitude Way property as the family residence without interruption until they
moved out in 2011.
When petitioners purchased the Solitude Way property, Mr. Smith intended
to improve the property and ultimately offer it for rent or sale consistent with his
past practice. In that regard, and throughout 2009, Mr. Smith spent much of his
leisure time working to improve the property, particularly the drainage of the
backyard.
At no time in 2009 was the Solitude Way property either rented or held out
for rent by petitioners. Rather, as previously stated, it was used as their personal
residence.
Petitioners timely filed their 2009 Federal income tax return. On it,
petitioners reported total wage income of $172,922, including $96,801 of wages
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earned by Mr. Smith. After subtracting their losses listed on their Schedules E and
making other adjustments, petitioners reported adjusted gross income of $158,243.
Petitioners attached two Schedules E to their return and listed five rental
real estate properties thereon: (1) a single-family home at Vargas Drive, San Jose,
California (Vargas Drive property); (2) a single-family home at Amber Lane,
Pleasanton, California (Amber Lane property); (3) a single-family home at
Garfield Drive, Petaluma, California (Garfield Drive property); (4) a farm at
Gibson Hill Road, Albany, Oregon; and (5) a residential rental at Santiago Court,
Novato, California (Santiago Court property). Petitioners did not include the
Solitude Way property on either of their Schedules E. Petitioners did, however,
claim a home mortgage interest deduction and a real estate tax deduction in
respect of the Solitude Way property on their Schedule A, Itemized Deductions,
for 2009.
On their Schedules E petitioners reported a net loss of $26,971. Petitioners
did not make the election to group their rental activities as a single activity at the
time they prepared and filed their return, nor did they seek to make the election at
any time thereafter.
In 2011 petitioners prepared a log reflecting the time spent in 2009 devoted
to both the Solitude Way property and their properties listed on their Schedules E.
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Each entry in the log includes the date, type of activity, and the property or
properties connected with the activity. At trial petitioners acknowledged that the
entries in the log are estimates of the time Mr. Smith spent performing specified
activities on given days.
The log estimates the total hours spent on real estate activities to be 1,411.2
hours. Petitioners added 10 hours of time spent brokering the properties, bringing
the total to 1,421.2 hours. The log reflects that petitioners devoted the following
hours to each property: 134.7 hours to the Vargas Drive property; entries related
to the Santiago Court property but no time allocated; 24 hours to the Garfield
Drive property; 28 hours to the property labeled Rental CA; 12 hours to the Amber
Lane property; 42.5 hours to the property labeled Rental Utah; 1,068 hours to the
Solitude Way property; 102 hours designated to all properties for routine
maintenance such as collecting rent; and 10 hours to brokering the properties.
Petitioners’ log further estimates that Mr. Smith spent 1,240 hours working
as a software engineer for his employers during 2009.
In March 2012 respondent issued petitioners a notice of deficiency,
determining a deficiency of $9,673 for 2009. The notice of deficiency disallowed
petitioners’ passive activity loss deductions claimed on their Schedules E.
Petitioners filed a timely petition for redetermination with the Court.
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Discussion
I. Burden of Proof
In general, the Commissioner’s determination in a notice of deficiency is
presumed correct, and the taxpayer bears the burden of proving that the
determination is incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). Pursuant to section 7491(a), the burden of proof as to factual matters
shifts to the Commissioner under certain circumstances. Petitioners have neither
alleged that section 7491(a) applies nor have they established their compliance
with its requirements. Accordingly, petitioners bear the burden of proof. See Rule
142(a); Welch v. Helvering, 290 U.S. at 115.
Deductions are allowed solely as a matter of legislative grace. Deputy v. du
Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435,
440 (1934). A taxpayer bears the burden of proving entitlement to any deduction
claimed. See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); Welch v. Helvering, 290 U.S. at 115. In addition, a taxpayer is required to
maintain records sufficient to substantiate deductions claimed on a Federal income
tax return. Sec. 6001; sec. 1.6001-1(a), (e), Income Tax Regs. In other words, the
taxpayer bears the burden of proving entitlement to the deductions claimed, and
this includes the burden of substantiation. Rule 142(a); Hradesky v.
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Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir.
1976).
II. Real Estate Professional
Section 469(a) generally disallows for the taxable year any passive activity
loss. A “passive activity loss” is defined as the excess of the aggregate losses
from all passive activities for the taxable year over the aggregate income from all
passive activities for that year. Sec. 469(d)(1). A “passive activity” includes, with
certain exceptions, any trade or business in which the taxpayer does not materially
participate. Sec. 469(c)(1). Rental activity is generally treated as a per se passive
activity regardless of whether the taxpayer materially participates. Sec. 469(c)(2),
(4). In general, material participation is defined as regular, continuous, and
substantial involvement by an individual in the operations of an activity. Sec.
469(h)(1).
There is an exception that allows the current deductibility of losses
associated with rental activities that would ordinarily be disallowed under section
469. Moss v. Commissioner, 135 T.C. 365, 368 (2010). Thus, a taxpayer who
engages in the rental real estate business is not engaged in a passive activity under
section 469(c)(2) if the taxpayer can show that he or she is a qualifying real estate
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professional under section 469(c)(7). See also sec. 1.469-9(e)(1), Income Tax
Regs.
A taxpayer qualifies as a real estate professional whose rental activities are
not deemed per se passive if:
(i) more than one-half of the personal services performed in
trades or businesses by the taxpayer during such taxable year are
performed in real property trades or businesses in which the taxpayer
materially participates, and
(ii) such taxpayer performs more than 750 hours of services
during the taxable year in real property trades or businesses in which
the taxpayer materially participates.
Sec. 469(c)(7)(B).3 For joint filers, the same spouse must satisfy each of the above
conjunctive requirements. Sec. 469(c)(7)(B)(ii). Here, petitioners allege (and the
record supports) that Mr. Smith was the spouse who was primarily involved in the
real estate activities.
Respondent contends that petitioners may not include the Solitude Way
property in their time estimates because that property was their personal residence
throughout 2009; therefore, in respondent’s view, petitioners have not established
that they worked the requisite number of hours to qualify as real estate
3
An individual must establish that he or she materially participated in each
of the rental activities unless the individual makes an election to treat all interests
in rental real estate as a single rental activity. Sec. 1.469-9(e)(1), Income Tax
Regs. Petitioners concede they made no such election.
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professionals under section 469(c)(7)(B). Respondent further contends that the
time log provided by petitioner should not be accepted because it was created
postevent and contains “ballpark guesstimate[s]” of dates and time spent on real
estate activities.
In contrast, petitioners contend that they only used the Solitude Way
property as their personal residence to allow Mr. Smith to more easily prepare the
property for rental. Therefore, in petitioners’ view, hours spent improving the
Solitude Way property should be included in determining whether petitioners
materially participated in real estate trades or businesses.
In seeking to make their case, petitioners point to section 280A regarding
the business use of home, as well as section 1.280A-1(e)(6), Proposed Income Tax
Regs., 45 Fed. Reg. 52399 (Aug. 7, 1980), as amended, 48 Fed. Reg. 33320 (July
21, 1983). Petitioners argue that the Code and the regulation provide that days
spent engaging in repair and maintenance work on a dwelling unit are not
considered days of personal use of the property. According to petitioners, because
Mr. Smith performed repair and maintenance work on the Solitude Way property
approximately full time during 2009, their dwelling in the property was not for
personal use and the hours spent improving the property are includible in
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determining whether Mr. Smith materially participated in real estate trades or
businesses during 2009.
A. Inclusion of Hours Spent Working on the Solitude Way Property
An activity involving the use of tangible property may be considered a
rental activity if such property is “used by customers or held for use by
customers”. Sec. 1.469-1T(e)(3)(i)(A), Temporary Income Tax Regs., 53 Fed.
Reg. 5702 (Feb. 25, 1988); sec. 1.469-9(b)(3), Income Tax Regs. In the instant
case, petitioners used the Solitude Way property throughout 2009 as their family
residence. Mr. Smith spent much of his leisure time in 2009 improving the
Solitude Way property, especially the backyard, with the intent that the Solitude
Way property might be rented out and used by tenants in the future; however, the
property was not actually rented out at any time during 2009, nor was it held out
for rent at any time in 2009. Therefore, regardless of petitioners’ intent to rent out
the Solitude Way property at a later date, it was not a rental activity in 2009
because it was neither used by customers nor held for use by customers. See sec.
1.469-1T(e)(3)(i)(A), (ii)(A), Temporary Income Tax Regs., supra.
Because the Solitude Way property was not part of a real estate trade or
business at any time in 2009, time spent improving the property may not be
included in establishing compliance with the real estate professional test of section
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469(c)(7)(B) for rental real estate activities. See Bailey v. Commissioner, T.C.
Memo. 2001-296. Therefore, after eliminating the hours Mr. Smith spent working
on the Solitude Way property from the activity log, the log reflects a total of only
353.2 hours spent working on other properties in 2009. Thus, even if petitioners
had elected to group their rental activities, which they did not, 353.2 hours is less
than the 1,240 hours Mr. Smith spent performing personal services in his
employment, see sec. 469(c)(7)(B)(i), and less than the 750-hour requirement
specified by section 469(c)(7)(B)(ii). Accordingly, petitioners do not qualify as
real estate professionals under section 469(c)(7).
Petitioners’ reliance on section 1.280A-1(e)(6), Proposed Income Tax
Regs., supra, is misplaced.4 Such section states that a taxpayer shall not be
deemed to have used a dwelling unit for personal purposes on any day on which
the principal purpose of the unit’s use was to perform repair or maintenance work
on the dwelling unit. However, throughout 2009 the principal purpose of
petitioners’ use of the Solitude Way property was not to perform repair or
4
In addition, we note that proposed regulations that have not been adopted
are generally not authoritative. See Canterbury v. Commissioner, 99 T.C. 223,
246 n.18 (1992) (citing F.W. Woolworth Co. v. Commissioner, 54 T.C. 1233,
1265-1266 (1970)); see also Flahertys Arden Bowl, Inc. v. Commissioner, 115
T.C. 269, 278 (2000) (stating that “[p]roposed regulations are not authoritative”),
aff’d, 271 F.3d 763 (8th Cir. 2001).
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maintenance work but rather to provide shelter, i.e., a home, for petitioners and
their five children, which was purely personal use. In short, section 280A is
simply inapposite given the actual use of the Solitude Way property.
B. Time Log Estimates
Even if the time Mr. Smith spent working on the Solitude Way property
could be considered and included in petitioners’ total hours working on real estate
activities, petitioners would not satisfy the requirements of section 469(c)(7)
because of the inadequacy of their log. In this regard, we observe that individuals
may establish the extent of their participation in an activity by “any reasonable
means.” Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727
(Feb. 25, 1988). Although “reasonable means” is interpreted broadly, we have
held that the phrase does not include a postevent “ballpark guesstimate”. Speer v.
Commissioner, T.C. Memo. 1996-323 (citing Goshorn v. Commissioner, T.C.
Memo. 1993-578).
The method used by petitioners to determine the time spent by Mr. Smith
performing services in his real estate activities was not reasonable within the
meaning of section 1.469-5T(f)(4), Temporary Income Tax Regs., supra. Thus,
petitioners rely on a reconstructed schedule of hours prepared in 2011 to
approximate daily or weekly time spent on each property in 2009. Although we
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found petitioners to be credible witnesses, we conclude that petitioners have not
demonstrated material participation because their records are postevent “ballpark
guesstimate[s]”. Accordingly, petitioners have not demonstrated that Mr. Smith
was a real estate professional in 2009.
III. Offset of Rental Real Estate Activities
Another exception that operates to allow the current deductibility of losses
associated with rental activities ordinarily disallowed under section 469, albeit a
potentially limited exception, is found in section 469(i). Thus, even if a taxpayer’s
rental real estate activities are treated as passive activities, a portion of the passive
activity losses associated with those activities may be deductible under section
469(i)(1). Thus, a taxpayer who “actively” participates in a rental real estate
activity may deduct a maximum loss of $25,000 per year related to the activity.
See sec. 469(i)(1) and (2). This exception is subject to a phaseout when the
taxpayer’s adjusted gross income (AGI) (determined without regard to any passive
activity loss) exceeds $100,000 and phases out entirely when adjusted gross
income reaches $150,000. Sec. 469(i)(3)(A); Moss v. Commissioner, 135 T.C.
371.
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Petitioners reported AGI (determined without regard to any passive activity
loss) of more than $150,000 on their 2009 return. Therefore, the phaseout
calculation serves to preclude any deductible loss for 2009.
Conclusion
In holding for respondent we have considered all of the arguments advanced
by petitioners, and, to the extent not expressly addressed, we conclude that those
arguments do not support a result contrary to that reached herein.
In order to give effect to the foregoing,
Decision will be entered for
respondent.