T.C. Summary Opinion 2009-145
UNITED STATES TAX COURT
NICHOLAS DAMER AND MARGARET FLYNN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4138-08S. Filed September 21, 2009.
Nicholas Damer and Margaret Flynn, pro sese.
John M. Wall, for respondent.
DEAN, Special Trial Judge: This case was heard pursuant to
the provisions of section 7463 of the Internal Revenue Code in
effect when the petition was filed. 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. Unless otherwise indicated, subsequent section references
are to the Internal Revenue Code in effect for the year in issue,
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and all Rule references are to the Tax Court Rules of Practice
and Procedure.
For 2005 respondent determined a $9,389 deficiency in
petitioners’ Federal income tax and a section 6662(a) accuracy-
related penalty of $1,878. The issues remaining1 for decision
are whether petitioners are: (1) Entitled to mortgage interest
deductions greater than the amounts respondent determined; (2)
entitled to deduct in 2005 a passive activity loss sustained in
2002; (3) subject to the passive activity loss limitations of
section 469; and (4) liable for a section 6662(a) accuracy-
related penalty.
Background
Some of the facts have been stipulated and are so found.
The stipulation of facts and the exhibits received into evidence
are incorporated herein by reference. When the petition was
filed, petitioners resided in California.
During 2005 petitioner Nicholas Damer (Mr. Damer) worked as
a licensed private investigator and as an attorney. Petitioner
Margaret Flynn worked as an independent contractor performing
pediatric physical therapy.
1
The amounts of petitioners’ tuition and fees deduction,
itemized deductions, alternative minimum tax, self-employment
tax, and self-employment tax deduction are computational matters
to be resolved in the parties’ Rule 155 computations consistent
with the Court’s decision. See secs. 55-59, 164(f), 222, 1401,
1402.
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Sometime in 1986 petitioners constructed an office building,
Liberty Court, which houses Mr. Damer’s law practice and is also
held by petitioners as rental real estate.
Over the years petitioners acquired several loans that were
used to construct or improve Liberty Court, to fund Mr. Damer’s
law practice, and to improve petitioners’ personal residence.
For example, in September 1998 petitioners acquired a $650,000
loan from First National Bank of Northern California (FNB) in
order to renew or modify an existing commercial real estate loan.
The FNB loan was secured by Liberty Court. In December 2005 they
acquired a $540,508.05 loan from Bank of America (BOA). The BOA
loan was used to pay off the FNB loan, and it too was secured by
Liberty Court. In December 2002 they acquired a $644,000 loan
from HomeComings Financial (HCF) that was secured by a first
mortgage on their residence. In January 2004 they acquired a
$100,000 line of credit from HCF that was secured by a second
mortgage on their residence. In October 2005 they acquired a
$975,340.58 loan from HCF. The 2005 HCF loan was used to pay off
the 2002 and 2004 HCF loans, and it also was secured by a first
mortgage on their residence. In November 2005 petitioners
acquired a $195,000 loan from Greenpoint Mortgage Funding, Inc.
(GMF), which was secured by a second mortgage on their residence.
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With each loan, petitioners financed certain fees, charges,
or taxes, and in some instances they received cash or “Refunds”
from the loan proceeds. They also claimed deductions for
mortgage interest, points, and fees, charges, or taxes on their
2005 Form 1040, U.S. Individual Income Tax Return. On Schedule
C, Profit or Loss From Business, they claimed a deduction for
mortgage interest of $58,057 with respect to Mr. Damer’s law
practice. On Schedule E, Supplemental Income and Loss, they
claimed deductions for mortgage interest of $31,868 and bank fees
of $33. On Schedule A, Itemized Deductions, they claimed
deductions for mortgage interest of $16,936 and points of $4,875.
During the examination of their return, Mr. Damer told
respondent’s Appeals officer that their deductions for mortgage
interest included points, fees, charges, or taxes from previous
loans that were paid when those loans were refinanced in 2005.
From third-party payor reports respondent determined that
petitioners paid mortgage interest of: (1) $28,034 to HCF; (2)
$35,945 to FNB; (3) $10,018 to HCF; and (4) $672 to HCF.
Respondent disallowed a portion of petitioners’ deductions for
mortgage interest because the amounts they claimed were more than
the amounts their lenders reported. Respondent then allocated
petitioners’ deductions for mortgage interest to Schedules C, E,
and A, respectively, because he could not match “specific
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mortgage interest to specific Forms or Schedules”.2 But
respondent made no adjustment to petitioners’ Schedule A
deduction for points of $4,875.
Discussion
I. Burden of Proof
The Commissioner’s determinations in a notice of deficiency
are presumed correct, and the taxpayer bears the burden to prove
that the determinations are in error. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). But the burden of proof on
factual issues that affect the taxpayer’s tax liability may be
shifted to the Commissioner if the taxpayer introduces credible
evidence with respect to the issue. Sec. 7491(a)(1).
Petitioners bear the burden of proof because they have neither
alleged that section 7491(a) applies nor proven that they have
complied with the substantiation and recordkeeping requirements
of section 7491(a)(2)(A) and (B).
II. Deductions for Mortgage Interest
A. General Principles
Taxpayers are generally allowed to deduct all interest paid
or accrued within the taxable year on indebtedness. Sec. 163(a).
But in the case of a taxpayer other than a corporation, no
deduction is allowed for personal interest. Sec. 163(h)(1).
2
It is unclear from the record the amounts of mortgage
interest from each loan that respondent allocated to each
schedule.
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“Personal interest” includes any interest allowable as a
deduction other than: (1) Interest paid or accrued on
indebtedness properly allocable to a trade or business (other
than the trade or business of performing services as an
employee); (2) any interest that is taken into account under
section 469 in computing income or loss from a passive activity
of the taxpayer; and (3) any qualified residence interest. Sec.
163(h)(2)(A), (C), (D). “[Q]ualified residence interest” means
any interest that is paid or accrued during the taxable year on
acquisition indebtedness3 or home equity indebtedness4 with
respect to any qualified residence of the taxpayer. Sec.
163(h)(3)(A). In addition, if a taxpayer prepays an interest
3
“[A]cquisition indebtedness” means any indebtedness that is
incurred in acquiring, constructing, or substantially improving
any qualified residence of the taxpayer and is secured by the
residence. Sec. 163(h)(3)(B)(i). Acquisition indebtedness also
includes any indebtedness secured by the residence resulting from
the refinancing of acquisition indebtedness but only to the
extent the amount of the indebtedness resulting from the
refinancing does not exceed the amount of the refinanced
indebtedness. Id. And the aggregate amount treated as
acquisition indebtedness for any period must not exceed $1
million ($500,000 if a married individual files a separate
return). Sec. 163(h)(3)(B)(ii).
4
“[H]ome equity indebtedness” means any indebtedness (other
than acquisition indebtedness) secured by a qualified residence
to the extent the aggregate amount of the indebtedness does not
exceed the fair market value of the qualified residence reduced
by the amount of acquisition indebtedness with respect to the
residence. Sec. 163(h)(3)(C)(i). And the aggregate amount
treated as home equity indebtedness for any period must not
exceed $100,000 ($50,000 if a married individual files a separate
return). Sec. 163(h)(3)(C)(ii).
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obligation and computes his/her taxable income under the cash
method of accounting, then the prepayments of interest must be
spread over the term of the loan and deducted to the extent that
monthly payments on the loan include the ratable portions (except
certain “points” deductible pursuant to section 461(g)(2)). Sec.
461(g)(1); Schubel v. Commissioner, 77 T.C. 701, 702-703 (1981);
Jackson v. Commissioner, T.C. Memo. 2005-159.
For cash method taxpayers, like petitioners, a deduction
requires that mortgage interest be paid in cash or its
equivalent. Don E. Williams Co. v. Commissioner, 429 U.S. 569,
578-579 (1977); Eckert v. Burnet, 283 U.S. 140, 141 (1931); Menz
v. Commissioner, 80 T.C. 1174, 1185 (1983). A promissory note is
generally not considered the equivalent of cash but merely a
promise to pay. Helvering v. Price, 309 U.S. 409, 413 (1940);
Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601, 624
(1964). If the obligation to pay mortgage interest is satisfied
through the issuance of notes to the same lender to whom the
mortgage interest obligation is owed, there has been no payment
of mortgage interest; rather, payment has merely been postponed.
Davison v. Commissioner, 107 T.C. 35, 41 (1996), affd. 141 F.3d
403 (2d Cir. 1998); Stone v. Commissioner, T.C. Memo. 1996-507.
As defined in caselaw “interest” means “compensation for the
use or forbearance of money.” Deputy v. du Pont, 308 U.S. 488,
498 (1940). Therefore, amounts characterized as mortgage
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interest must be distinguished from fees, charges, or taxes,
which are computed without regard to the amount borrowed, the
duration of the loan, the degree of credit risk, or the condition
of the money market. Id.; Pac. First Fed. Sav. & Loan
Association v. Commissioner, 79 T.C. 512 (1982). To the extent
that the loan proceeds were used for business or investment
purposes, the fees or charges might be deductible over the life
of the loan under section 162(a) or 212. Goodwin v.
Commissioner, 75 T.C. 424, 439-442 (1980), affd. 691 F.2d 490 (3d
Cir. 1982); Wilkerson v. Commissioner, 70 T.C. 240, 262-263
(1978), revd. on other grounds 655 F.2d 980 (9th Cir. 1981);
Lovejoy v. Commissioner, 18 B.T.A. 1179 (1930); Trivett v.
Commissioner, T.C. Memo. 1977-161, affd. 611 F.2d 655 (6th Cir.
1979).
In addition, certain fees, charges, or taxes--such as
recording or transfer fees/taxes--are costs of acquiring the
property and must be capitalized and included in the property’s
basis pursuant to section 263(a)(1). Thompson v. Commissioner, 9
B.T.A. 1342, 1345 (1928); Erfurth v. Commissioner, T.C. Memo.
1987-232; Gibbons v. Commissioner, T.C. Memo. 1976-125.
If the loan proceeds were used for personal purposes, then
the fees, charges, or taxes cannot be deducted or capitalized
(except certain “points” deductible pursuant to section
461(g)(2)). Sec. 262(a); Hendrick v. Commissioner, 35 T.C. 1223,
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1235 (1961); Rev. Rul. 67-297, 1967-2 C.B. 87 (loan origination
fee (or points) paid in connection with the acquisition of a home
mortgage loan guaranteed by the Veterans’ Administration is a
charge for services and is neither deductible as interest nor
treated as an additional cost of the property); cf. Goodwin v.
Commissioner, supra at 439-442.
With these principles in mind, the Court now turns to
petitioners’ deductions for mortgage interest and related fees,
charges, or taxes.
B. FNB Mortgage Interest and Related Fees, Charges, or
Taxes
Petitioners provided a BOA loan document that shows that
they used some of the BOA loan proceeds to pay mortgage interest
of $1,613.36 to FNB in December 2005.
The Court finds that petitioners paid mortgage interest of
$1,613.36 to FNB in December 2005 from the BOA loan proceeds.
But because petitioners have not proven that the $1,613.36 was
not included in the $35,945 that respondent allowed as a
deduction for mortgage interest paid to FNB in 2005, they
nevertheless are not entitled to deduct the $1,613.36. See
Davison v. Commissioner, supra at 41; Stone v. Commissioner,
supra.
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The FNB loan document shows that petitioners also financed:
Description Amount
“Modification Endorsement 110.5 Fee” $850
Recording 50
Tax lien service fee 55
Document preparation fee 250
Flood certificate fee 40
Loan fees 6,500
Pursuant to Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d
Cir. 1930), the Court finds that petitioners are entitled under
sections 162(a) and/or 2125 to deductions of $2,821.72 for the
fees or charges that were paid or incurred in 2005.6 See Crown
v. Commissioner, 77 T.C. 582, 593-595 (1981); Wilkerson v.
Commissioner, supra at 262-263; McAdams v. Commissioner, 15 T.C.
231, 234-235 (1950), affd. 198 F.2d 54 (5th Cir. 1952). In
addition, consistent with petitioners’ previous Federal income
tax returns, they should allocate the deductible amounts equally
to Schedules C and E. See Estate of Ashman v. Commissioner, 231
F.3d 541, 543 (9th Cir. 2000), affg. T.C. Memo. 1998-145. But
petitioners are not entitled to deduct the recording fee. See
5
An individual’s rental real estate activity can constitute
a trade or business for purposes of sec. 162(a). See, e.g.,
Hazard v. Commissioner, 7 T.C. 372 (1946). But see, e.g.,
Balsamo v. Commissioner, T.C. Memo. 1987-477 (rental real estate
activity did not constitute a trade or business; rather, the
property was held for the production of income within the meaning
of sec. 212(1)).
6
$7,695 (total allowable FNB loan fees or charges) ÷ 10
years (amortization period) = $769.50 per year ÷ 12 months (per
year) = $64.13 per month x 44 months (remaining amortization
period of the FNB loan as of Jan. 1, 2005) = $2,821.72.
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Thompson v. Commissioner, supra at 1345; Erfurth v. Commissioner,
supra; Gibbons v. Commissioner, supra.
C. BOA Mortgage Interest and Related Fees, Charges, or
Taxes
Petitioners have not shown that they paid mortgage interest
to BOA in 2005; therefore, they are not entitled to a mortgage
interest deduction for that loan. See secs. 163(a), 6001.
The BOA loan documents show that petitioners also financed:
Description Amount
Flood fee $30
Reconveyance fee 15
Documentation fee 30
“ALTA” loan policy premium (title insurance) 1,146
Endorsements (title insurance) 100
Escrow fee 850
Recording fee 20
Recording fee for reconveyance to come 20
Notary fees 20
“Overnight/Courier/Misc.” fees 60
Pursuant to Cohan v. Commissioner, supra at 543-544, the
Court finds that petitioners are entitled to deduct under
sections 162(a) and/or 212 the 2005 amortizable amounts of the
fees or charges (i.e., $18.637). See Crown v. Commissioner,
supra at 593-595; Wilkerson v. Commissioner, supra at 262-263;
McAdams v. Commissioner, supra at 234-235. Again, petitioners
7
Petitioners failed to establish the amortization period of
the BOA loan. The Court assumes that the BOA loan was
amortizable over 10 years. See Cohan v. Commissioner, 39 F.2d
540, 543-544 (2d Cir. 1930). Thus, $2,236 (total allowable BOA
loan fees or charges) ÷ 10 years (amortization period) = $223.60
per year ÷ 12 months (per year) = $18.63 per month x 1 month
(Dec. 2, 2005)= $18.63.
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should allocate the deductible amounts equally to Schedules C and
E. See Estate of Ashman v. Commissioner, supra at 543. But
petitioners are not entitled to deduct the reconveyance fee,
recording fee, or recording fee for reconveyance to come. See
Thompson v. Commissioner, 9 B.T.A. at 1345; Erfurth v.
Commissioner, T.C. Memo. 1987-232; Gibbons v. Commissioner, T.C.
Memo. 1976-125.
D. HCF and GMF Mortgage Interest and Related Fees, Charges,
or Taxes
1. Mortgage Interest
Respondent contends that because petitioners obtained the
proceeds to pay off the 2002 and 2004 HCF loans from the same
lender and never had unfettered access to the funds used to pay
off those loans, they are not entitled to deduct the outstanding
interest obligations (i.e., $3,811.958) that were paid when they
refinanced the 2002 and 2004 HCF loans with the 2005 HCF loan.
Petitioners, on the other hand, contend that the HCF and GMF
loans “in part, refinanced debt going back to the 1970’s and
related to [p]etitioner Damer’s law practice.” Therefore,
according to petitioners, they are entitled to deduct any
mortgage interest paid in 2005 and to deduct any fees, charges,
8
The $3,811.95 is based on mortgage interest of $340.58 +
$1,872.36 + $1,515.72 + $45.04 + $38.25 from Sept. 9 to Oct. 8,
2005.
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or taxes to the extent that they were paid or incurred to finance
Mr. Damer’s law practice.
The Court finds that petitioners are not entitled to deduct
the outstanding interest obligations of the 2002 and 2004 HCF
loans that were “paid” with the 2005 HCF loan because the
interest was not paid within the meaning of section 163(a). See
Davison v. Commissioner, 107 T.C. at 41. The Court therefore
finds that petitioners’ HCF mortgage interest deductions are
limited to the amounts respondent determined; i.e., $28,034,
$10,018, and $672. In addition, the amounts should be allocated
to Schedules A and C according to the percentages of each loan
that the Court has determined were used to finance Mr. Damer’s
law practice, see infra pp. 16-18; i.e.: (1) 85.2 percent to
Schedule A and 14.8 percent to Schedule C for the 2002 HCF loan;
(2) 85.8 percent to Schedule A and 14.2 percent to Schedule C for
the 2004 HCF loan; and (3) 60.4 percent to Schedule A and 39.6
percent to Schedule C for the 2005 HCF loan.9
Petitioners have not shown that they paid mortgage interest
to GMF in 2005; therefore, they are not entitled to a mortgage
interest deduction for that loan. See secs. 163(a), 6001.
9
It is unclear from the notice of deficiency (and the
record) which HCF loan is attributable to the amounts respondent
allowed for mortgage interest deductions. The Court leaves this
to the parties to sort out in their Rule 155 computations.
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2. HCF- and GMF-Related Fees, Charges, or Taxes
The 2002 HCF loan document shows that petitioners financed:
Description Amount
Loan origination fee $3,220.00
Appraisal fee 500.00
Credit report 20.00
Tax service 98.00
Document fee 161.00
Closing fee 100.00
Underwriting fee 350.00
Flood certificate fee 10.50
Wire fee 5.00
Demand/statement fee 50.00
ALTA loan policy fee 1,315.55
Recording trust deed 59.00
Escrow fee 350.00
Notary fee 40.00
Courier/overnight fee 30.00
The 2002 HCF loan document does not show the amortization
period of that loan. But it shows that petitioners received a
refund of $95,376.66 from the loan proceeds.
The 2004 HCF loan document shows that petitioners financed:
Description1 Amount
Loan origination fee $1,000.00
Credit report 20.00
Funding review fee 95.00
Processing fee 395.00
Additional items 195.50
Title insurance 110.00
Recording trust deed 25.00
Escrow fee 250.00
Notary fee 60.00
Courier/overnight fee 30.00
1
Petitioners were also required to pay in advance hazard
insurance of $3,663 and “Banana Republic misc. acct” of $24.
Petitioners, however, have not shown that the amount of the
hazard insurance attributable to Mr. Damer’s law practice was not
deductible in 2004. See sec. 1.263(a)-4(f)(1), (8), Income Tax
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Regs. Thus, petitioners cannot deduct any portion of the hazard
insurance in 2005. In addition, the Court surmises, and
petitioners have not proven otherwise, that the $24 for Banana
Republic misc. acct was a personal expenditure. Consequently,
petitioners are not entitled to deduct any portion of that amount
in 2005. See sec. 262(a).
The 2004 HCF loan document does not show the amortization
period of that loan. But it shows that petitioners received cash
of $14,162.50 from the loan proceeds.
The 2005 HCF loan document shows that petitioners financed:
Description1 Amount
Appraisal fee $150
Credit report 35
Tax service 128
Funding review fee 266
Processing fee 395
Underwriting fee 450
Flood certificate fee 6
Wire fee 5
Demand/statement fee 44
ALTA loan policy fee 1,785
1st lender endorsement
(title insurance) 50
Recording trust deed 75
Escrow fee 500
Notary fee 40
Courier/overnight fee 45
1
Petitioners also financed a loan origination fee of $4,875
that they deducted on Schedule A as points, and respondent made
no adjustment to it. See supra pp. 4-5.
The 2005 HCF loan document shows that petitioners financed
the principal and related fees, charges, or taxes for a 30-year
amortization period. It also shows that petitioners received a
refund of $386,041.93 from the loan proceeds.
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The GMF loan document shows that petitioners financed:
Description Amount
Document fee $295
Processing fee 395
“CB Tahoe for misc. collection” 133
Notary fee 60
ALTA loan policy fee 617
Recording trust deed 65
Escrow fee 250
Courier/overnight fee 30
“Edocs” processing fee 50
The GMF loan document does not show the amortization period
of that loan. In addition, it shows that petitioners did not
receive cash or a refund from the loan proceeds.
To the extent that the fees or charges were incurred in
connection with the acquisition, construction, or improvement of
petitioners’ residence, the fees or charges are nondeductible
personal expenses (except the deduction for points of $4,875 that
respondent allowed). See sec. 262(a); Goodwin v. Commissioner,
75 T.C. at 439-442; Hendrick v. Commissioner, 35 T.C. at 1235.
To the extent that the fees or charges were incurred in
connection with Mr. Damer’s law practice, petitioners are
entitled to deduct those amounts under section 162(a) as
determined infra. See Goodwin v. Commissioner, supra at 439-442;
Wilkerson v. Commissioner, 70 T.C. at 262-263. But in no case
are petitioners entitled to deduct the recording fees. See
Thompson v. Commissioner, 9 B.T.A. at 1345; Erfurth v.
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Commissioner, T.C. Memo. 1987-232; Gibbons v. Commissioner, T.C.
Memo. 1976-125.
Petitioners failed to establish the amount of the proceeds
of each loan that was used to finance Mr. Damer’s law practice.
Pursuant to Cohan v. Commissioner, 39 F.2d at 543-544, the Court
finds that only 14.810 percent of the 2002 HCF loan was used to
finance Mr. Damer’s law practice. The Court also finds that the
2002 HCF loan was amortizable over 30 years. See id. Therefore,
petitioners are entitled to a deduction of $829.8811 under
section 162(a) for the outstanding amortizable fees or charges of
the 2002 HCF loan that were paid or incurred in 2005. See id.
The Court finds that only 14.212 percent of the 2004 HCF
loan was used to finance Mr. Damer’s law practice. See id. The
Court also finds that the 2004 HCF loan was amortizable over 30
years. See id. Therefore, petitioners are entitled to a
deduction of $299.2613 under section 162(a) for the outstanding
10
$95,376.66 (refund) ÷ $644,000 (2002 HCF loan).
11
$6,250.05 (total allowable 2002 HCF loan fees or charges)
÷ 30 years (amortization period) = $208.34 (amortizable per year)
÷ 12 months (per year) = $17.36 per month x 323 months (remaining
amortization period/months as of Jan. 1, 2005) x 14.8% (loan
proceeds attributed to law practice) = $829.88.
12
$14,162.50 (cash) ÷ $100,000 (2004 HCF loan).
13
$2,180 (total allowable 2004 HCF loan fees or charges) ÷
30 years (amortization period) = $72.67 (amortizable per year) x
29 years (remaining amortization period as of Jan. 1, 2005) x
14.2% (loan proceeds attributed to law practice) = $299.26.
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fees or charges of the 2004 HCF loan that were paid or incurred
in 2005. See id.
The Court finds that only 39.614 percent of the 2005 HCF
loan was used to finance Mr. Damer’s law practice. See Cohan v.
Commissioner, supra at 543-544. Therefore, petitioners are
entitled to a deduction of $12.8715 under section 162(a) for the
fees or charges that were paid or incurred with respect to the
2005 HCF loan. See id.
The Court finds, however, that no portion of the 2005 GMF
loan was used to finance Mr. Damer’s law practice; petitioners
have not proven otherwise. See id. Consequently, petitioners
are not entitled to deduct any fees or charges with respect to
the 2005 GMF loan. See id.
E. 2002 Mortgage Interest Carried Over to 2005
Mr. Damer testified that when their 2002 Federal income tax
return was audited in 2005, respondent disallowed Schedule E
deductions of $27,900 because the amount exceeded the passive
activity loss limitations of section 469. Petitioners contend
that they are entitled to carry over the 2002 passive activity
loss to 2005. They assert that 51.54 percent of that amount
14
$386,041.93 (refund) ÷ $975,340.58 (2005 HCF loan).
15
$3,899 (total allowable 2005 HCF loan fees or charges) ÷
30 years (amortization period) = $129.97 (amortizable per year) ÷
12 months (per year)= $10.83 x 3 months (Oct. 4 to Dec. 31, 2005)
x 39.6% (loan proceeds attributed to law practice) = $12.87.
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(i.e., $14,380) was interest and that the amount can be added to
the mortgage interest deductions claimed on their 2005 Schedules
C and E.
Section 469(b), however, provides that if any loss or credit
from an activity is disallowed under section 469(a), then the
loss or credit is treated as a deduction or credit allocable to
the activity in the next taxable year. See also sec. 1.469-
1(f)(4), Income Tax Regs. (any disallowed deductions or credits
are allocated among the taxpayer’s activities for the succeeding
taxable year). Consequently, petitioners’ $27,900 passive
activity loss from 2002 was to be carried over to 2003, not to
2005. Petitioners also failed to establish that any of the 2002
passive activity loss remains to be deducted in 2005 after being
carried over to 2003 and then to 2004.16 See Wilkinson v.
Commissioner, 71 T.C. 633, 639 (1979); Halle v. Commissioner, 7
T.C. 245, 247-250 (1946), affd. 175 F.2d 500 (2d Cir. 1949);
Baker v. Commissioner, T.C. Memo. 2008-247 (statements in tax
returns are only claims of the taxpayer, not proof of his/her
deductions or losses).
16
On Form 8582, Passive Activity Loss Limitations,
petitioners reported a prior year’s unallowed loss of $39,087.
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III. Passive Activity Loss Limitations
On petitioners’ 2005 Schedule E and Form 8582, they reported
passive activity losses of $68,660,17 of which they reported zero
as their “Deductible rental real estate loss”. They claimed that
amount (i.e., zero) on line 17 of their Form 1040.
Petitioners contend that they are not subject to the passive
activity loss limitations of section 469 and that they are
entitled to deduct their Schedule E losses without limit because
they meet the test for material participation.
Section 469(a) generally disallows any passive activity
loss18 or passive activity credit.19 The term “passive activity”
includes any trade or business in which the taxpayer does not
materially participate, any activity engaged in for the
production of income, and any rental activity regardless of
whether the taxpayer materially participates.20 Sec. 469(c)(1),
17
Based on 2005 losses of $19,030 (property A) + $5,327
(property B) + $5,216 (property C) + $39,087 (prior years’
unallowed losses).
18
“Passive activity loss” means the excess of the aggregate
losses over the aggregate income from all passive activities.
Sec. 469(d)(1).
19
“Passive activity credit” means the amount, if any, by
which the sum of the credits from all passive activities
allowable for the taxable year under subpt. D of pt. IV of subch.
A or subpt. B (other than sec. 27(a)) exceeds the regular tax
liability of the taxpayer for the taxable year allocable to all
passive activities. Sec. 469(d)(2).
20
Material participation means that the taxpayer is involved
in the activity’s operations on a regular, continuous, and
(continued...)
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(2), (4), (6). But under section 469(c)(7) rental activities of
a qualifying taxpayer in a real property trade or business are
not a per se passive activity under section 469(c)(2). Kosonen
v. Commissioner, T.C. Memo. 2000-107. Rather, the qualifying
taxpayer’s rental activities are treated as a trade or business--
subject to the material participation requirements of section
469(c)(1). Fowler v. Commissioner, T.C. Memo. 2002-223; sec.
1.469-9(e)(1), Income Tax Regs.
A taxpayer may qualify for the real property trade or
business exception if: (1) More than one-half of the personal
services performed in trades or businesses by the taxpayer during
the taxable year are performed in real property trades or
businesses in which the taxpayer materially participates; and
(2) the 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)(i) and
(ii). In the case of a joint return, either spouse must satisfy
both requirements. Sec. 469(c)(7)(B).
Each petitioner failed to establish that more than one-half
of the personal services he/she performed in trades or businesses
were performed in real property trades or businesses during 2005
20
(...continued)
substantial basis. Sec. 469(h); see also sec. 1.469-5T(a),
Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988) (an
individual is treated as materially participating if the
individual satisfies any one of the seven enumerated tests).
- 22 -
and that he/she performed more than 750 hours of services during
2005 in real property trades or businesses. Thus, the Court need
not decide whether they materially participated. Consequently,
petitioners’ passive activity losses or credits for 2005 are
limited by section 469.
IV. Accuracy-Related Penalty
Respondent determined a section 6662(a) accuracy-related
penalty based on petitioners’ substantial understatement of their
2005 Federal income tax.21
In pertinent part, section 6662(a) and (b)(2) imposes an
accuracy-related penalty equal to 20 percent of the underpayment
that is attributable to a substantial understatement of income
tax. A substantial understatement of income tax exists if the
amount of the understatement for the taxable year exceeds the
greater of 10 percent of the tax required to be shown on the
return for the taxable year or $5,000. Sec. 6662(d)(1)(A). The
term “understatement” means the excess of the amount of the tax
required to be shown on the return for the taxable year over the
amount of the tax imposed that is shown on the return less any
rebate as defined by section 6211(b)(2). Sec. 6662(d)(2)(A).
The amount of the understatement is reduced by the portion of the
understatement that is attributable to: (1) The taxpayer’s tax
21
The Court therefore need not discuss whether petitioners
were negligent or disregarded rules or regulations. See sec.
6662(b); Fields v. Commissioner, T.C. Memo. 2008-207.
- 23 -
treatment of the item if there is or was substantial authority
for the treatment; or (2) any item if the relevant facts
affecting the item’s tax treatment are adequately disclosed in
the return or in a statement attached to the return and there is
a reasonable basis for the taxpayer’s tax treatment of the item.
Sec. 6662(d)(2)(B).22
Initially, the Commissioner has the burden of production
with respect to any penalty, addition to tax, or additional
amount. Sec. 7491(c). The Commissioner satisfies this burden of
production by coming forward with sufficient evidence that
indicates that it is appropriate to impose the penalty. See
Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the
Commissioner satisfies this burden of production, the taxpayer
must persuade the Court that the Commissioner’s determination is
in error by supplying sufficient evidence of an applicable
exception. Id.
In view of the computational adjustments, see supra note 1,
and the Court’s holdings herein, it is unclear whether there is a
substantial understatement of income tax for 2005. The Court
leaves for the parties to determine as part of the Rule 155
computations whether there is a substantial understatement. If a
substantial understatement exists, petitioners are liable for the
22
Petitioners have not proven that they satisfy the adequate
disclosure and substantial authority provisions. See sec.
6662(d)(2)(B).
- 24 -
accuracy-related penalty because respondent will have met his
burden of production and petitioners have not established a
reasonable cause or good faith defense.
V. Conclusion
In sum, respondent’s determinations are sustained except as
otherwise stated; and to the extent that a substantial
understatement of income tax exists, petitioners are liable for a
section 6662(a) accuracy-related penalty.
To reflect the foregoing,
Decision will be entered
under Rule 155.