Madler v. Commissioner

T.C. Memo. 1998-112

UNITED STATES TAX COURT

JAMES R. & ANITA MADLER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 773-97. Filed March 18, 1998.

James R. Madler, pro se.

Mayer Y. Silber, for respondent.

MEMORANDUM OPINION

PANUTHOS, Chief Special Trial Judge: This case was heard

pursuant to the provisions of section 7443A(b)(3) and Rules 180,
 - 2 -

181, and 182.1 Respondent determined deficiencies in

petitioners' Federal income taxes as follows:

Year Amount

1991 $3,029
1992 676
1993 296

After concessions,2 the only issue remaining for decision is

whether petitioners qualify for the $25,000 offset for rental

real estate activities under section 469(i) for the taxable years

1991, 1992, and 1993.

The facts have been fully stipulated. The stipulation of

facts and the attached exhibits are incorporated herein by this

reference. At the time of filing the petition, petitioners

resided at Chicago, Illinois.

During the years in issue, petitioner James Madler

(hereinafter sometimes referred to as petitioner) was self-

employed as an attorney, and petitioner Anita Madler was not

1
All section references are to the Internal Revenue Code
in effect during the years in issue, unless otherwise indicated.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
2
Petitioners have conceded: (1) They failed to report
income in the amount of $3,478 on their 1991 return; (2) they
failed to report wages in the amount of $571 on their 1991
return; (3) they failed to report income in the amount of $350 on
their 1993 return; and (4) they are not entitled to claim
deductions for the taxable years 1991 through 1993 resulting from
losses attributable to property they owned in Cloudcroft, New
Mexico. The remaining adjustments are computational and are
dependent upon our resolution of the issue for decision.
 - 3 -

employed. On or about April 30, 1981, petitioner purchased a

condominium unit (hereinafter referred to as the condominium

unit) in Corpus Christi, Texas. Petitioner entered into a rental

agency agreement, effective January 1, 1988, with Villa Del Sol

Condominiums (VDS). Under the terms of the agreement, petitioner

retained VDS as the exclusive agent to rent the condominium unit,

and VDS was obligated to use its best efforts to do so.

During the taxable years in issue, between 275 and 293 units

were subject to rental agency agreements with VDS. Pursuant to

these agreements, including the agreement with petitioner, VDS

pooled items of income and expense from all participating units

and allocated to each unit owner a ratable share of income and

expenses. Thus, VDS did not determine each owner's share of

income and expenses based upon whether the unit was actually

rented; rather, VDS determined each owner's share based upon the

number of days in which the unit was available for rental. The

agreement, however, required petitioner to provide the initial

furnishings of the condominium unit, subject to the approval of

VDS. Petitioner was also obligated to provide the unit with a

19-inch television, a cassette stereo, a telephone, and a

prescribed deadbolt lock.

The agreement required VDS to employ and manage all

necessary personnel, including professional management, for

implementation of the condominium unit's rental operation and
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upkeep of the premises. The agreement required VDS to pay for

the cost of repair and replacement of the unit's furnishings and

household items, which would then be assessed as a shared expense

of the condominium association. VDS was also responsible for

paying all utility bills allocable to the unit, although

petitioner retained ultimate liability for those expenses. Items

of expense incurred by VDS on behalf of unit owners include:

Front desk, telephone, housekeeping, maintenance, administration,

accounting, marketing, replacement reserves, and electricity.

Furthermore, the unit was available to VDS for up to 5 days per

calendar year for promotional purposes, without payment of rent

to petitioner. Lastly, the agreement could be terminated at

will.

The record does not reflect the average period of customer

use of petitioner's unit. On Schedule E of their returns for the

taxable years in issue, petitioners reported income and claimed

expenses concerning their rental real estate as follows:

1991 1992 1993

Rent received $ 8,829 $ 9,513 $ 9,063
Expenses including depreciation (15,003) (14,284) (14,491)

Loss 6,174 4,771 5,428

A portion of the losses reflected on Schedules E for each of the

years in issue relates to petitioner's condominium unit.3

3
The items of income and expense reflected on petitioners'
(continued...)
 - 5 -

Petitioners then fully deducted these losses on line 18 of their

returns (Forms 1040) for each of the years in question. Only the

portion of the losses attributable to petitioner's condominium

unit remains in issue. Upon examination, respondent disallowed

the claimed losses, reasoning that petitioner's ownership of the

condominium unit constituted a passive activity for purposes of

section 469, thereby precluding petitioners from offsetting

losses attributable to the unit against nonpassive income.

Discussion

We begin by noting that petitioners bear the burden of

proving that respondent's determination is erroneous. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). This

burden remains when a case is fully stipulated. Borchers v.

Commissioner, 95 T.C. 82, 90-91 (1990), affd. 943 F.2d 22 (8th

Cir. 1991). Moreover, deductions are a matter of legislative

grace, and petitioners bear the burden of proving that they are

entitled to any of the deductions claimed. INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992).

Section 162 permits deductions for all the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on a trade or business. Section 212 permits deductions

3
(...continued)
returns are attributable to the condominium unit in question in
addition to property owned by petitioners in Cloudcroft, New
Mexico. Since there is no allocation on the returns, or
elsewhere in the record, we have included the entire amounts.
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for all the ordinary and necessary expenses paid or incurred

during the taxable year for the production of income. Section

469(a)(1) and (d)(1) generally prohibits a taxpayer from claiming

deductions attributable to "passive activities" in an amount

which exceeds the income generated by that taxpayer's "passive

activities". Scheiner v. Commissioner, T.C. Memo. 1996-554;

Mordkin v. Commissioner, T.C. Memo. 1996-187. The term "passive

activity" includes: (1) Any activity which involves the conduct

of a trade or business and in which the taxpayer does not

materially participate, and (2) any rental activity without

regard to whether or not the taxpayer materially participates in

the activity. Sec. 469(c)(1), (2), (4).

For purposes of section 469, the term "rental activity" is

defined in section 469(j)(8) as any activity where payments are

principally for the use of tangible property. See also sec.

1.469-1T(e)(3)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5702

(Feb. 25, 1988). An activity involving the use of tangible

property, however, is not considered a rental activity for a

taxable year if for such taxable year the average period of

customer use for such property is 7 days or less. Sec. 1.469-

1T(e)(3)(i) and (ii)(A), Temporary Income Tax Regs., 53 Fed. Reg.

5702 (Feb. 25, 1988). Therefore, owners of rental real estate

are not considered to be engaged in a rental activity if the
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average period of customer use is 7 days or less. Scheiner v.

Commissioner, supra.

Section 469(i)(1) and (2) provides:

(i) $25,000 Offset for Rental Real Estate
Activities.--

(1) In general.--In the case of any
natural person, subsection (a) shall not
apply to that portion of the passive activity
loss * * * which is attributable to all
rental real estate activities with respect to
which such individual actively participated
in such taxable year * * *.

(2) Dollar limitation.--The aggregate
amount to which paragraph (1) applies for any
taxable year shall not exceed $25,000.

In effect, section 469(i) allows the taxpayer to offset from

nonpassive income up to $25,000 of certain passive activity

losses.4 With respect to the limited applicability of the

$25,000 offset to losses attributable to "rental real estate

activities", the legislative history of section 469 explains:

Since relief under this rule applies only to
rental real estate activities, it does not apply to
passive real estate activities that are not treated as
rental activities under the provision (e.g., an
interest in the activity of operating a hotel). * * *
[S. Rept. 99-313 (1986), 1986-3 C.B. (Vol. 3) 1, 737.]

Congress, therefore, intended that taxpayers should be entitled

to the $25,000 offset for losses attributable to "rental real

4
The $25,000 offset allowable under sec. 469(i) is phased
out as adjusted gross income, modified by sec. 469(i)(3)(E),
exceeds $100,000, with a full phase-out occurring when modified
adjusted gross income equals $150,000. Sec. 469(i)(3)(A).
 - 8 -

estate activities" only if the activity constitutes a "rental

activity".

With respect to the requirement that the individual actively

participate in the rental real estate activity, the legislative

history of section 469 also provides:

The difference between active participation and
material participation is that the former can be
satisfied without regular, continuous, and substantial
involvement in operations, so long as the taxpayer
participates, e.g., in the making of management
decisions or arranging for others to provide services
(such as repairs), in a significant and bona fide
sense. Management decisions that are relevant in this
context include approving new tenants, deciding on
rental terms, approving capital or repair expenditures,
and other similar decisions.

* * * * * * *

[A]s with regard to the material participation
standard, services provided by an agent are not
attributed to the principal, and a merely formal and
nominal participation in management, in the absence of
a genuine exercise of independent discretion and
judgment, is insufficient. [S. Rept. 99-313, supra,
1986-3 C.B. (Vol. 3) at 737-738.]

In determining whether a taxpayer actively participates, the

participation of the taxpayer's spouse is taken into account.

Sec. 469(i)(6)(D).

The arguments of the parties on brief focus on the question

of whether petitioners actively participated in the activity of

renting petitioner's condominium unit for the purpose of allowing

petitioners the offset provided at section 469(i). It is not

clear from the record, however, whether petitioner's condominium
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unit was rented for an average period of greater than 7 days for

each of the years in issue. Therefore, it is unclear whether the

activity in question constitutes a rental real estate activity

under section 469(i).5

Since the record is vague as to the average period of

customer use of the condominium unit, and since application of

the relevant provisions differs depending upon whether the

average period exceeds 7 days, we shall address whether

petitioners are entitled to the claimed losses under either

scenario.

1. Average Period of Customer Use Greater Than 7 Days

If the average period of customer use of petitioner's

condominium unit was greater than 7 days, the activity of renting

the unit is considered a rental real estate activity, and

petitioners must establish that they actively participated in

that activity to qualify for the offset under section 469(i). To

support their contention that they actively participated in the

rental of the condominium unit, petitioners argue as follows:

Code Section 469(i) gives an "out" to those taxpayers
who fall within the $25,000.00 offset provision. This
"out" is limited to those taxpayers which "actively
participated" in the rental of property. [Petitioners]
submit that they qualify under this exception in that
they participate and make management decisions on a

5
As previously indicated, if the average period of
customer use is 7 days or less, the activity is not considered a
rental activity. Sec. 1.469-1T(e)(3)(i) and (ii)(A), Temporary
Income Tax Regs., 53 Fed. Reg. 5702 (Feb. 25, 1988).
 - 10 -

monthly basis. This decision making process occurs
each month in which a rental income or expense
statement is received from the rental agreement. At
that time a management decision is made whether to
continue or terminate the participation in the rental
agreement * * * in that the rental agreement is
terminable at will * * *.

* * * [Petitioners] may at any time elect to
provide the rental services themselves or to procure
another agent for these services. Under these
conditions the Petitioners are making significant and
[bonafide] management decisions on a month-to-month
basis whether to continue, cancel, or make another
agency relationship.

Petitioners have offered no evidence to indicate that they

personally approved of tenants, decided rental terms, approved of

expenditures for repairs and capital improvements, or in any way

participated in the management of the unit in a significant and

bona fide sense. It appears that VDS, rather than petitioners,

performed all significant management activities. Moreover, we do

not consider petitioner's ability to terminate the contract with

VDS as active participation per se; the legislative history of

section 469 explains that taxpayers must themselves genuinely

exercise independent discretion and judgment. On the basis of

the record before us, we conclude that petitioners have failed to

establish that they actively participated in the activity of

renting the condominium unit during each of the years in issue.

Therefore, assuming that the average period of customer use of

petitioner's condominium unit was greater than 7 days,
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petitioners are not entitled to the $25,000 offset provided at

section 469(i).

2. Average Period of Customer Use Less Than 7 Days

If the average period of customer use of petitioner's

condominium unit was 7 days or less, petitioner was not engaged

in a rental activity. Therefore, the activity of renting

petitioner's condominium unit does not constitute a "rental real

estate activity" for purposes of section 469(i), and petitioners

are not entitled to use the $25,000 offset provided therein.

Although the activity of renting petitioner's unit does not

constitute a rental activity under this assumption, the activity

will not be considered a passive activity if petitioners can

establish that they materially participated in the activity.

Sec. 469(c)(1)(B). Material participation is defined as

involvement in the operations of an activity on a regular,

continuous, and substantial basis. Sec. 469(h)(1). A taxpayer

can establish material participation by satisfying one of seven

tests provided in the regulations. Sec. 1.469-5T(a), Temporary

Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1988); see

also Mordkin v. Commissioner, T.C. Memo. 1996-187. In this

instance, however, we see no reason to set forth these tests and

discuss at length whether petitioners have satisfied any one of

them. Petitioners have offered little information concerning

whether their involvement in the operation of petitioner's unit
 - 12 -

was regular, continuous, and substantial. Petitioners have not

established that they materially participated in the activity in

question; therefore, they are not entitled to claim as a

deduction the losses in question. Accordingly, we sustain

respondent's determination on this issue.

To reflect the foregoing,

Decision will be entered

for respondent.