T.C. Summary Opinion 2004-112
UNITED STATES TAX COURT
ALEXANDER FIRSOW AND CAMILLA THOMAS-FIRSOW, a.k.a. CAMILLA
THOMAS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13284-02S. Filed August 24, 2004.
James D. McCarthy, Jr., for petitioners.
Bradley C. Plovan, for respondent.
PANUTHOS, Chief Special Trial Judge: This case was heard
pursuant to the provisions of section 7463 of the Internal
Revenue Code in effect at the time the petition was filed. The
decision to be entered is not reviewable by any other court, and
this opinion should not be cited as authority. Unless otherwise
indicated, subsequent 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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Respondent determined deficiencies and penalties in
petitioners’ 1999 and 2000 Federal income taxes as follows:
Penalty
Year Deficiency Sec. 6662(a)
1999 $4,886 $977.20
2000 5,642 1,128.40
The issues for decision are: (1) Whether the passive activity
rules of section 469 preclude petitioners from deducting the full
amounts of losses from their rental real estate activities for
the 1999 and 2000 taxable years, and (2) whether petitioners are
liable for accuracy-related penalties for the 1999 and 2000
taxable years pursuant to section 6662(a).
Background
Some of the facts have been stipulated, and they are so
found. The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time their
petition was filed, petitioners resided in Abingdon, Maryland.
During the years in issue, petitioners were employees of
Ashley, Inc., which is located in Havre de Grace, Maryland.
Petitioner Camilla Thomas-Firsow worked full time as an employee,
whereas petitioner Alexander Firsow (petitioner) worked 32 hours
per week. In addition to being an employee of Ashley, Inc.,
petitioner also operated a horse racing business.
Also during the years in issue, petitioners owned two rental
properties. One was located at 309 Rowland Drive, Port Deposit,
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Maryland (Port Deposit property). The other was located at 2539
Harbor Lane, Sanibel, Florida (Sanibel property).
The Sanibel property was rented for approximately 1 month
during 1999 and for approximately 3 weeks during 2000. The Port
Deposit property was rented throughout 1999 and 2000. Petitioners
spent no more than 2 weeks per year at the Sanibel property,
performing maintenance work, but also fishing off the pier.
Petitioners filed joint Federal income tax returns for the
1999 and 2000 taxable years. For 1999, petitioners reported on
their Schedule E, Supplemental Income and Loss, a loss of $25,712
from rental real estate for the Port Deposit property and the
Sanibel property. For 2000, petitioners reported a loss on
Schedule E of $29,493 for the same properties.
For each of the taxable years, the Schedule E filed by
petitioners contained the following cautionary language:
“Caution: Your rental real estate loss * * * may be limited.
See page E-3 to find out if you must file Form 8582. Real estate
professionals must complete line 42 on page 2.” Despite this
language, petitioners left blank line 42 of Schedule E, dealing
with “Reconciliation for Real Estate Professionals”. Moreover,
petitioners did not file a Form 8582, Passive Activity Loss
Limitations, with either of their joint returns for 1999 and
2000.
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On July 9, 2003, in response to an examination of their
returns, petitioners provided respondent a document entitled
“Election to Aggregate Activities” for the Port Deposit property,
Sanibel property, and other properties. This election was not
filed with petitioners’ joint returns for 1999 and 2000.
Respondent contends that petitioners are not entitled to
deduct the full amounts of losses associated with their rental
activity because of passive activity loss limitations under
section 469.1 Respondent further contends that petitioners are
liable for accuracy-related penalties under section 6662(a) due
to negligence or disregard of the rules or regulations.
Discussion
Whether losses attributable to rental real estate activities
are deductible in full depends upon the classification of such
activities. In general, a rental activity is a “passive
activity,” even if the taxpayer “materially participates” in such
activity. Sec. 469(c)(2), (4). The deductible amount of
aggregate losses from a rental activity for the taxable year is
thus limited to the aggregate income from all passive activities
for the corresponding year. The excess, if any, of the losses
over the income is a “passive activity loss”. Sec. 469(d)(1).
The passive activity loss is then disallowed as a deduction to
1
Respondent does not contest the amount of the reported
losses, but instead contests the extent to which petitioners are
entitled to deduct such losses.
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the extent that the taxpayer did not “actively participate” in
the rental real estate activity. Sec. 469(a)(1), (i)(1). In the
present case, respondent determined that petitioners actively
participated in their rental activity and thus are entitled to
deduct some, but not all, of their passive activity losses,
subject to the limitations under section 469(i).
Petitioners, however, classify their rental activity
differently. They contend that, during the taxable years in
issue, they were in the “real property trade or business” as that
term is defined under section 469(c)(7). If they were, then the
passive activity loss limitations of section 469 would not apply,
and petitioners would be entitled to deduct the full amount of
their losses for each year. See sec. 469(c)(7)(A)(i).
Deductions are a matter of legislative grace, and generally
the taxpayer bears the burden of proving entitlement to any
deduction claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner,
503 U.S. 79, 84 (1992). The burden of proof has not shifted to
respondent pursuant to section 7491(a). While examination of the
tax returns in issue commenced after July 22, 1998, neither of
the parties has addressed the applicability of section 7491(a).
Petitioners have not offered any evidence that they satisfied any
of the criteria of section 7491(a)(2)(A) and (B). Accordingly,
we conclude that the burden remains on petitioners to prove that
they were in the real property trade or business and that their
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rental real estate activity is not a passive activity for the
1999 and 2000 taxable years.
The term “real property trade or business” means any real
property development, redevelopment, construction,
reconstruction, acquisition, conversion, rental, operation,
management, leasing, or brokerage trade or business. Sec.
469(c)(7)(C). A taxpayer may elect to treat all interests in
rental real estate as one activity. Sec. 469(c)(7)(A); sec.
1.469-9(g)(1), Income Tax Regs. Such election is made by filing
a statement with the taxpayer’s original income tax return for
the taxable year. Sec. 1.469-9(g)(3), Income Tax Regs.
To qualify for the election, the taxpayer must satisfy two
requirements. First, more than one-half of the personal services
performed in trades or businesses by the taxpayer during such
taxable year must be performed in real property trades or
businesses in which the taxpayer materially participates. Sec.
469(c)(7)(B)(i). Second, such taxpayer must perform 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)(ii). In the case of a joint
return, both requirements must be satisfied by the same spouse.
Sec. 469(c)(7)(B).
Under both requirements, a taxpayer must materially
participate in a real property trade or business in order for the
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personal services provided by the taxpayer in that real property
trade or business to count. See sec. 469(c)(7)(B); sec. 1.469-
9(c)(3), Income Tax Regs. A taxpayer is treated as materially
participating in an activity only if the taxpayer is involved in
the operations of the activity on a basis which is regular,
continuous, and substantial. Sec. 469(h)(1). In determining
whether a taxpayer materially participates, the participation of
the taxpayer’s spouse is taken into account. Sec. 469(h)(5).
The temporary Treasury regulations promulgated under section 469
provide:
The extent of an individual’s participation in an
activity may be established by any reasonable means.
Contemporaneous daily time reports, logs, or similar
documents are not required if the extent of such
participation may be established by other reasonable
means. Reasonable means for purposes of this paragraph
may include but are not limited to the identification
of services performed over a period of time and the
approximate number of hours spent performing such
services during such period, based on appointment
books, calendars, or narrative summaries.
Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg.
5727 (Feb. 25, 1988); see also sec. 1.469-9(b)(5), Income Tax
Regs. This Court has acknowledged that these temporary
regulations are somewhat ambivalent concerning the records to be
maintained by taxpayers, but we have held that the regulations do
not allow a post-event “ballpark guesstimate”. Fowler v.
Commissioner, T.C. Memo. 2002-223; Goshorn v. Commissioner, T.C.
Memo. 1993-578.
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To establish the amount of time petitioners spent on their
rental real estate activities in the present case, petitioners
introduced a spreadsheet and a daily work log summarizing the
work activities they performed on a daily basis for the Sanibel
property and Port Deposit Property. The daily work log was not
prepared contemporaneously as petitioners performed each
activity, but it was composed by petitioners in preparation for
an examination of their returns by respondent. The spreadsheet
lists the following hours spent by petitioners at their rental
properties:
Year Port Deposit property Sanibel property Total
1999 283 606 889
2000 311 494 805
Petitioner testified that he worked 12 hours per day whenever he
was at the Sanibel property. The spreadsheet also lists
petitioners’ time spent rendering personal services for their own
residence and for the properties owned by petitioner’s parents.
Petitioners have not met their burden of proving that they
were in the real property trade or business and that their rental
real estate activity is not a passive activity for the 1999 and
2000 taxable years. While petitioners did not file their
election to aggregate activities with their joint returns for
1999 and 2000, we need not decide whether we should look at the
total number of hours during each of these taxable years such
that petitioners spent 889 hours in 1999 and 805 hours in 2000.
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We find that their testimony, the spreadsheet, and the daily work
logs were not credible. Petitioners were employees of Ashley,
Inc., where she worked full time and he worked 32 hours a week.
In addition to his employment at Ashley, Inc., petitioner also
operated a horse racing business. Petitioners testified, and the
spreadsheet indicates, that they spent a fair amount of time
rendering personal services for their own residence and for the
properties owned by petitioner’s parents. Even if we were to
accept as true petitioner’s testimony that he worked 12 hours per
day at the Sanibel property (above and beyond his time fishing
off the pier), petitioners spent no more than 2 weeks per year
there. While petitioners have spent some time performing
personal services at their rental properties, we conclude that
such time falls short of the “more than 750 hours of services”
required under section 469(c)(7). Accordingly, we sustain
respondent’s determination regarding this issue.
The final issue is whether petitioners are liable for
accuracy-related penalties under section 6662(a) for the 1999 and
2000 taxable years. An accuracy-related penalty “applies to any
portion of an underpayment of tax required to be shown on a
return” where such portion is attributable to negligence or
disregard of rules or regulations. Sec. 6662(a) and (b)(1). The
term “negligence” includes any failure to make a reasonable
attempt to comply with the provisions of the Internal Revenue
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Code. Sec. 6662(c). The term “disregard” includes any careless,
reckless, or intentional disregard. Id. Respondent has the
burden of production with respect to the accuracy-related
penalties. See sec. 7491(c).
The courts have refined the Code definition of negligence as
a lack of due care or failure to do what a reasonable and prudent
person would do under similar circumstances. Allen v.
Commissioner, 925 F.2d 348, 353 (9th Cir. 1991), affg. 92 T.C. 1
(1989). Treasury regulations further provide that negligence
includes any failure to exercise ordinary and reasonable care in
the preparation of a tax return, failure to keep books and
records, or failure to substantiate items properly. Sec.
1.6662-3(b)(1), Income Tax Regs. A return position that has a
“reasonable basis” as defined in the regulation is not
attributable to negligence. Id.
An exception to the section 6662 penalty applies when the
taxpayer demonstrates: (1) There was reasonable cause for the
underpayment, and (2) the taxpayer acted in good faith with
respect to the underpayment. Sec. 6664(c).2 Whether the
taxpayer acted with reasonable cause and in good faith is
determined by the relevant facts and circumstances on a
case-by-case basis. See Stubblefield v. Commissioner, T.C. Memo.
2
This section may provide relief even if a return position
does not satisfy the reasonable basis standard. Sec. 1.6662-
3(b)(3), Income Tax Regs.
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1996-537; sec. 1.6664-4(b)(1), Income Tax Regs. “Circumstances
that may indicate reasonable cause and good faith include an
honest misunderstanding of fact or law that is reasonable in
light of all the facts and circumstances, including the
experience, knowledge, and education of the taxpayer.” Sec.
1.6664-4(b)(1), Income Tax Regs. A taxpayer is not subject to
the addition to tax for negligence where the taxpayer makes
honest mistakes in complex matters, but the taxpayer must take
reasonable steps to determine the law and to comply with it.
Niedringhaus v. Commissioner, 99 T.C. 202, 222 (1992). The most
important factor is the extent of the taxpayer’s effort to assess
the proper tax liability. Stubblefield v. Commissioner, T.C.
Memo. 1996-537; sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent has met his burden of production with respect to
the accuracy-related penalties under section 6662(a). The
returns filed by petitioners contained cautionary language that
they failed to heed. Petitioners did not maintain records for
their rental real estate activity, but produced the spreadsheet
and daily work log only in response to an examination of their
returns by respondent. Based upon these facts and circumstances,
we find that petitioners did not take reasonable steps to
determine the law and to comply with it. Moreover, petitioners
have failed to demonstrate that there was reasonable cause and
that they acted in good faith. Accordingly, we sustain
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respondent’s determination with respect to the accuracy-related
penalties under section 6662(a).
Reviewed and adopted as the report of the Small Tax Case
Division.
To reflect the foregoing,
Decision will be entered
for respondent.