T.C. Memo. 1996-56
UNITED STATES TAX COURT
B. THEODORE AND WENDY CHAPIN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12106-94. Filed February 14, 1996.
Ps own a beach condominium that is rented for an
average period of 7 days or less during the June to
September rental season. A rental agent handles all leasing
arrangements, cleaning between tenants, and routine repairs
and maintenance. Ps allege that they spend more than 170
hours during the nonrental season on cleaning and
maintaining the condominium. Held: For purposes of sec.
469, I.R.C., Ps' participation in the activity does not
constitute participation on a regular, continuous, and
substantial basis. Accordingly, the losses incurred are
subject to the passive loss rules of sec. 469, I.R.C.
E. Gregory Lardieri and E. Newton Steely, Jr. (specially
recognized), for petitioners.
John C. Donovan, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION
POWELL, Special Trial Judge: This case was assigned
pursuant to the provisions of section 7443A(b)(3) and Rules 180,
181, and 182.1
Respondent determined deficiencies in petitioners' Federal
income taxes in the following amounts:
Year Deficiency
1987 $1,694
1988 8,337
1989 9,930
1990 9,511
1991 2,089
The issue is whether deductions related to the expenses of
renting a beach condominium owned by petitioners are limited by
the passive activity loss limitations of section 469.
FINDINGS OF FACT
During the years 1987 through 1991, and at the time of
filing the petition, petitioners resided in Silver Spring,
Maryland. Petitioner B. Theodore Chapin (Mr. Chapin) worked full
time as vice president of American Digital Systems Corp. until
December of 1990, at which time he organized and began working
full time for his own corporation, Applied Software, Inc.
Petitioner Wendy Chapin (Mrs. Chapin) is a housewife/artist who
1
Unless otherwise indicated, section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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specializes in copying paintings that are displayed in the
National Gallery of Art in Washington, D.C. She does not
generally sell these reproductions.
During the years at issue, petitioners owned various rental
properties. In 1987, petitioners owned properties in Apopka,
Florida, and Silver Spring, Maryland. In 1988, petitioners
acquired another property in Silver Spring, Maryland. In 1989,
petitioners purchased property in Takoma Park, Maryland, and a
third property in Silver Spring, Maryland. These properties were
generally leased for 1 year terms.
Petitioners also own a condominium apartment (the
condominium) in Ocean City, Maryland. The condominium was
purchased in 1986 and consisted of two bedrooms, two full
bathrooms, a kitchen, a living room/dining room area, a
laundry/utility room, and a balcony. The condominium was rented
to tenants between June and September (the rental season). The
average rental term was 7 days or less for each of the years at
issue.
Petitioners left the day-to-day management of the property
in the hands of O'Conor, Piper & Flynn (the rental agent). The
rental agent's duties included advertising the property for rent,
receiving calls from prospective tenants, showing the condominium
to prospective tenants, dispensing and collecting keys,
collecting rent and deposits from tenants, hiring a cleaning
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service to clean between rentals, hiring maintenance people to
perform repairs on the premises, and preparing owner's reports
detailing the income and expenses of the rental.
Petitioners testified that they spent between 170.5 and
193.5 hours every year in various activities relating to the
condominium. This alleged participation consisted of: Cleaning
(39.5-50.5 hours), shopping (8 hours), general maintenance (29-31
hours), travel to and from Ocean City (70-80 hours),2 and
repainting (24 hours). Petitioners purportedly spent an
additional 24 hours in both 1988 and 1990 painting the entire
condominium, and Mrs. Chapin spent 32 hours in 1987 and an
additional 35 hours painting copies of paintings to hang on the
walls of the condominium.3
Petitioners did not maintain a log or other record of their
hours of participation. Petitioners introduced credit card
receipts from restaurants and other commercial enterprises in
Ocean City or the vicinity to corroborate their testimony that
they were in the area seven to eight times a year between the end
of one commercial rental season in September and the beginning of
2
Travel time consisted of seven to eight trips per year
at 5 hours per round trip for both petitioners.
3
Mrs. Chapin was uncertain as to the years in which this
participation occurred.
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the next in June.4 The driving time from Silver Spring to Ocean
City is approximately 2-1/2 hours.
Petitioners filed joint Federal income tax returns claiming
a business loss on Schedule C from the rental of the condominium
for each of the taxable years at issue. The claimed losses,
after agreed-upon adjustments, were in the following amounts:
Year Loss
1987 $25,341
1988 26,861
1989 23,953
1990 22,493
1991 21,056
In the notice of deficiency, respondent determined that the
rental of the condominium was a passive activity, and, therefore,
petitioners' claimed losses for each year were suspended pursuant
to section 469.
OPINION
Section 162 allows deductions for all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on a trade or business. Section 212 allows deductions
for all the ordinary and necessary expenses paid or incurred
during the taxable year for the production of income or the
management or maintenance of property held for the production of
4
The receipts showed that petitioners were in Ocean City,
or the vicinity, between five and eight times per year.
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income. Section 469, however, limits the deductions for losses
from a "passive activity". A passive activity means any activity
(A) which involves the conduct of any trade or
business, and
(B) in which the taxpayer does not materially
participate. [Sec. 469(c)(1).]
Generally, an activity in which payments are received
principally for the use of tangible property by customers is a
"rental activity". Sec. 469(j)(8); sec. 1.469-1T(e)(3)(i)(A),
Temporary Income Tax Regs, 53 Fed. Reg. 5702 (Feb. 25, 1988).
All rental activities are deemed passive. Sec. 469(c)(2), (4);
sec. 1.469-1T(e)(1), Temporary Income Tax Regs., 53 Fed. Reg.
5702 (Feb. 25, 1988). However, if the average period of customer
use of the property is 7 days or less, the activity is not
considered to be a "rental activity". Sec. 1.469-
1T(e)(3)(ii)(A), Temporary Income Tax Regs., 53 Fed. Reg. 5702
(Feb. 25, 1988). Nonetheless, an activity falling outside the
definition of a rental activity will be passive if the taxpayer
does not materially participate in the activity. Sec. 469(c)(1);
sec. 1.469-1T(e)(1), Temporary Income Tax Regs., supra.
An individual materially participates in an activity when
involved in the operations of the activity on a regular,
continuous, and substantial basis. Sec. 469(h)(1). Pursuant to
section 469(l)(1), the Secretary has issued regulations that
specify what constitutes material participation. Section 1.469-
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5T(a)(2), (3), and (7), Temporary Income Tax Regs., 53 Fed. Reg.
5725-5726 (Feb. 25, 1988), provides, in relevant part, that an
individual shall be treated as materially participating if the
individual meets any of the following tests:
(2) The individual's participation in the
activity for the taxable year constitutes substantially
all of the participation in such activity of all
individuals (including individuals who are not owners
of interests in the activity) for such year;
(3) The individual participates in the activity
for more than 100 hours during the taxable year, and
such individual's participation in the activity for the
taxable year is not less than the participation in the
activity of any other individual (including individuals
who are not owners of interests in the activity) for
such year;
* * * * * * *
(7) Based on all of the facts and circumstances
(taking into account the rules of paragraph (b) of this
section), the individual participates in the activity
on a regular, continuous, and substantial basis during
such year.
The "material participation standard identifies an important
distinction between different types of taxpayer activities." S.
Rept. 99-313, at 716 (1986), 1986-3 C.B. (Vol. 3) 1, 716. The
focus of section 469 is directed to suspending the so-called tax
preferences unless there is "substantial and bona fide
involvement in the activities to which the preferences relate."
Id. It is necessary "to examine the materiality of a taxpayer's
participation in an activity in determining the extent to which
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such taxpayer should be permitted to use tax benefits from the
activity." Id.
It is important, therefore, to define the activity subject
to the limits of section 469. For income tax purposes there are
generally two economic interests involved in the ownership of
real estate--the value of the asset as an investment, and if
rented, the value of the rental income. As to the first, the
value of the asset may appreciate or depreciate, and, the
resulting gain or loss is generally recognized as a capital
transaction when the property is sold even though the economic
gain or loss was realized over the years that the property was
owned. See sec. 1001. On the other hand, the leasing activity
gives rise to gross income and deductions, and the net income or
loss generally is realized and recognized during each taxable
year that the property is rented. See secs. 61, 441. When
section 469 applies to rental real estate, it operates to suspend
losses from the leasing activity. Accordingly, we will use the
terms "activity" and "leasing activity" interchangeably.
In this case, the average lease period of the condominium
was 7 days or less during the years at issue, and, therefore, the
leasing activity is not a "rental activity" for purposes of
section 469(c)(2). Sec. 1.469-1T(e)(3)(ii)(A), Temporary Income
Tax Regs., supra. While the leasing activity falls outside the
definition of a "rental activity", section 469 nonetheless
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applies if petitioners did not materially participate in the
activity. Sec. 469(c)(1).
Petitioners assert that they meet the so-called safe harbor
requirements of section 1.469-5T(a)(2), Temporary Income Tax
Regs., supra. That section provides that the taxpayer's
participation must constitute "substantially all of the
participation in such activity of all individuals" during the
years at issue. But the rental of the condominium required
continual involvement in the leasing and day-to-day management of
the property. The rental agent had complete responsibility for
these activities, and, therefore, petitioners' participation did
not constitute "substantially all of the participation" in the
activity.
Petitioners also assert that they meet the "safe harbor"
requirements of section 1.469-5T(a)(3), Temporary Income Tax
Regs., supra. To satisfy this test, petitioners must establish
that (1) they participated in the activity for more than 100
hours each year, and (2) no other individual's participation
exceeded petitioners' participation during each year. Regardless
whether petitioners satisfy the first requirement, they have not
established that no other participation exceeded their
participation in the activity. The rental agent not only
advertised, showed, and rented the property, but was also
routinely available to handle complaints, repairs, etc. Further,
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after each tenant, a cleaning service cleaned the property.
While we do not know how much time these services took, they
involve a substantial amount of time. It is petitioners' burden
to show that they satisfy the requirements of section 1.469-
5T(a)(3), Temporary Income Tax Regs., supra, and they have failed
to meet that burden.5
Petitioners alternatively contend that, if they fail the so-
called safe harbor provisions of paragraphs (a)(2) and (3) of
section 1.469-5T, Temporary Income Tax Regs., supra, they
nonetheless satisfy the requirements of section 1.469-5T(a)(7),
Temporary Income Tax Regs., supra. Section 1.469-5T(a)(7),
Temporary Income Tax Regs., supra, mirrors the statutory
definition of "material participation" set out in section
469(h)(1) and requires that petitioners show they participated in
the activity on a regular, continuous, and substantial basis
during each year. As an initial matter, petitioners'
participation must exceed 100 hours each year. Sec. 1.469-
5T(b)(2)(iii), Temporary Income Tax Regs., 53 Fed. Reg. 5726
(Feb. 25, 1988). Measuring participation in terms of time may be
useful in setting minimum requirements and in defining safe
5
No witness from the rental agency testified. Mr. Chapin
attempted to testify as to his estimate of the hours spent by the
rental agent in connection with the rental and maintenance of the
condominium. Respondent objected on the ground that Mr. Chapin
did not have personal knowledge of that fact. The objection was
sustained.
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harbors, but the deductibility of a loss under section 469(h)(1)
depends also on regular and continuous participation in the
activity.
While we have grave doubts concerning the time allegedly
spent by petitioners,6 even if that time would satisfy the
minimum requirement of the regulation, the work performed by
petitioners in connection with the leasing activity was not
regular and continuous participation. We reemphasize here, the
activity with which we are concerned is the rental of the
property. As we have already outlined, the rental of the
condominium to many different tenants over the course of the
rental season required substantial work and time. The rental
agent advertised, showed the condominium, collected rent and
deposits from tenants, collected and dispensed keys, hired a
cleaning service to clean the condominium between tenants, hired
maintenance people to perform repairs on the premises, and
maintained an office to receive calls from tenants and
6
We are not persuaded that the time allegedly spent by
petitioners is an accurate reflection of what transpired.
Petitioners claim to have spent 5 to 6 hours cleaning two
bathrooms, 8 hours cleaning a kitchen, and 5 hours "refreshing"
plastic floral arrangements. We are left with the conclusion
that much of the total time allegedly spent was exaggerated or,
if not, was spent primarily for the purposes of avoiding the
limitations of sec. 469. See sec. 1.469-5T(f)(2), Temporary
Income Tax Regs., 53 Fed. Reg. 5726-5727 (Feb. 25, 1988). As set
out above, however, time is not the only measure of an
individual's participation. We, therefore, do not find it
necessary to determine the amount of time that petitioners spent
on the rental activity.
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prospective tenants. A cleaning service cleaned the condominium
after each tenant vacated the premises throughout the rental
season. Maintenance workers performed repairs to the
condominium. The performance of this work constituted the
regular and continuous participation in the activity, and notably
absent was any participation by petitioners. Petitioners'
contribution to the activity consisted of a single, albeit
thorough, cleaning of the condominium after each rental season.
They may have extended this participation over six or eight
weekends during the nonrental seasons, but their contribution to
the activity did not constitute participation on a basis that was
regular and continuous.7
Based on the foregoing, we find that petitioners did not
materially participate in this activity.
7
The report of the Finance Committee notes:
Another factor that may be highly relevant in
showing regular, continuous, and substantial
involvement in the operations of an activity, and
thereby establishing material participation, is
whether, and how regularly, the taxpayer is present at
the place or places where the principal operations of
the activity are conducted. For example, in the case
of an employee or professional who invests in a horse
breeding activity, if the taxpayer lives hundreds of
miles from the site of the activity, and does not often
visit the site, such taxpayer is unlikely to have
materially participated in the activity. * * * [S.
Rept. 99-313, at 733 (1986), 1986-3 C.B. (Vol. 3) 1,
733.]
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Decision will be entered
for respondent.