Garrison v. Comm'r

T.C. Memo. 2010-261

UNITED STATES TAX COURT

WENDELL V. AND SHARON T. GARRISON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 19988-07, 19989-07. Filed December 1, 2010.

Wendell V. and Sharon T. Garrison, pro sese.

Roger W. Bracken, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GOEKE, Judge: Respondent determined deficiencies in

petitioners’ Federal income tax and additions to tax under
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section 6651(a)(1) for 1998, 1999, and 2000.1 After concessions,

the issues remaining for decision are:2

(1) Whether petitioners’ gains from sales of real property

during tax years 1998-2000 were ordinary income or capital gain;

(2) whether petitioners are liable for self-employment

taxes;

(3) whether petitioners are entitled to deduct additional

costs associated with the gross income received from purchasing

and selling real property;

(4) whether petitioners are liable for income tax on

dividends received;

(5) whether petitioners are liable for income tax on

interest received in 1998;

(6) whether petitioners must reduce their itemized

deductions for all years and their child tax credit for 1998;

(7) whether petitioners are liable for a failure to timely

file addition to tax pursuant to section 6651(a)(1).

We resolve these issues against petitioners, except we hold that

respondent has not carried the burden of proof with respect to

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
2
Respondent concedes the gain on the foreclosure sale of one
property known as the Dumbarton property.
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the increased deficiencies and additions to tax asserted in his

amended answer.

FINDINGS OF FACT

Petitioners resided in Maryland when they filed their

petitions. On March 22, 2002, petitioners filed their delinquent

joint Federal income tax returns for tax years 1998, 1999, and

2000.

On June 8, 2007, respondent issued a notice of deficiency

(notice). On September 4, 2007, petitioners timely filed their

petitions in this Court for tax years 1998, 1999, and 2000. The

notice mailed to petitioners reflects, among other adjustments, a

recharacterization of petitioners’ real estate transactions.

Specifically, respondent classified income from these

transactions as ordinary income from a trade or business rather

than royalty income, or capital gains as petitioners now claim.3

Respondent made additional adjustments, some resulting from his

recharacterization of the income from real estate sales. The

overall adjustments are as follows:

1998 1999 2000

Schedule C: Income $834,000 $604,500 $473,000

Capital gain or loss -0- 27 -0-

Self-employment tax 13,240 13,789 16,439

Self-employment tax deduction (6,620) (6,895) (8,220)

3
Petitioners contend that they incorrectly reported proceeds
from sales of real estate as royalty income on their returns, and
they now argue that the proceeds should be capital gains.
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Cost of goods sold (656,315) (426,000) (212,000)

Dividend income 38 38 37

Interest income 50 -0- -0-

Schedule E: Royalty income (63,991) (47,121) (73,464)

Itemized deductions (44,328) (16,656) 1,478

Exemptions -0- -0- 8,064

During tax years 1998 through 2000, petitioners regularly

purchased and sold real estate within short periods. Petitioner

husband earned not more than $40,000 annually as a mortgage

banker, and petitioners’ purchases and sales of real estate

contributed substantially to their income. Many of the

properties petitioners purchased were in foreclosure.

In 1998 petitioners sold eight parcels of real property.

Petitioners did not claim expenses or repairs for any of these

properties on their 1998 Form 4797, Sales of Business Property.

Petitioners sold all those properties within 2 months of

purchase, with one exception. In 1999 and 2000 petitioners sold

four parcels of real property each year. Petitioners listed

expenses and repairs on their 1999 Form 4797. Petitioners sold

each property within 10 weeks of acquiring it. Over the 3 years

petitioners did not rent any of the properties before selling

them.

Trial was held on December 7 and 9, 2009, in Washington,

D.C. On March 11, 2009, the Court had granted respondent’s

motion for leave to amend the answer. Respondent’s amended
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answer asserted increased deficiencies and section 6651(a)(1)

additions to tax as follows:

Original Increased
Original Increased sec. 6651(a)(1) sec. 6651(a)(1)
Year deficiency deficiency additions to tax additions to tax

1998 $27,118 $69,298 $6,779 $17,324
1999 32,532 84,259 8,133 21,052
2000 65,751 109,348 16,473 35,489

Respondent’s increased deficiencies and additions to tax are

based on property sale proceeds not included in the notice of

deficiency. Those proceeds increased petitioners’ self-

employment taxes and their adjusted gross income. The changes to

petitioners’ adjusted gross income resulted in increased self-

employment tax deductions and reductions in itemized deductions

and exemptions.

On his posttrial brief, respondent again revised his

position regarding unreported income from petitioners’ real

estate transactions as follows (the amounts in the notice of

deficiency are shown as well):

Notice of deficiency
net real estate Revised self-
income adjustment to employment income
self employment per respondent’s
Year income brief

1998 $177,685 $196.138.79
1999 178,729 112,505.08
2000 261,000 196,607.57
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At trial petitioners submitted Forms 1040X, Amended U.S.

Individual Income Tax Return, for these years. Petitioners also

entered into the record Forms 4797 which listed the costs of

repairs and expenses for real estate. Both sets of documents

were admitted to help the Court understand petitioner husband’s

testimony. However, petitioners produced no receipts, invoices,

or any other evidence to substantiate the expenses petitioners

claim they paid on their real estate ventures. Respondent

submitted deeds and Forms HUD-1, Settlement Statement, for the

properties petitioners purchased and sold during the years at

issue and used these documents to calculate the gains by

subtracting from sale proceeds the purchase and settlement costs.

OPINION

I. Burden of Proof

The taxpayer bears the burden of proving by a preponderance

of the evidence that the Commissioner’s determinations in the

notice of deficiency are incorrect. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). Deductions are a matter of

legislative grace, and a taxpayer bears the burden of proving

entitlement to any claimed deductions. Rule 142(a)(1); INDOPCO,

v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934). In general, the burden of

proof with regard to factual matters rests with the taxpayer.

Under section 7491(a), if the taxpayer produces credible evidence
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with respect to any factual issue relevant to ascertaining the

taxpayer’s liability for tax and meets other requirements, the

burden of proof shifts from the taxpayer to the Commissioner as

to that factual issue. Petitioners have not alleged that section

7491(a) applies or established their compliance with its

requirements.

Section 6214(a) grants the Court jurisdiction to redetermine

a deficiency and to determine whether any additional amounts or

any additions to tax should be assessed. Respondent may assert

an increased amount under section 6214(a); however, with respect

to the increased deficiencies and section 6651(a)(1) additions to

tax, respondent bears the burden of proof. After briefing, the

increased deficiency respondent seeks is for 1998. Petitioners

bear the burden of proof with respect to the deficiencies and

additions to tax determined in the deficiency notice. See Rule

142(a).

II. Issues

A. Capital Gain or Ordinary Income

The first issue is whether petitioners are entitled to

capital gains treatment for proceeds of their property sales.4

Respondent argues that the real estate petitioners purchased and

sold was held primarily for sale to customers in the ordinary

4
Although petitioners claimed royalty income on their
returns, they now claim the income should be treated as capital
gains.
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course of petitioners’ trade or business of real estate

refurbishment and not for investment. If petitioners held the

property primarily for sale to customers in the ordinary course

of business, as respondent argues, petitioners’ gains will be

treated as ordinary income.

1. Section 1221

Petitioners assert they purchased real estate for the

purpose of holding it for investment and with the intent of

renting it. Respondent argues that petitioners’ intent was to

resell the property. A “capital asset” is broadly defined as

property held by the taxpayer, whether or not connected with his

or her trade or business, subject to a number of exceptions.

Sec. 1221(a). These exceptions include stock in trade or other

property of a kind that is properly included in a taxpayer’s

inventory and property held primarily for sale to customers in

the ordinary course of the taxpayer’s trade or business. Id.

The Supreme Court has defined “primarily” as used in this

context to mean “principally” or “of first importance”. Malat v.

Riddell, 383 U.S. 569, 572 (1966); Biedenharn Realty Co. v.

United States, 526 F.2d 409, 422-423 (5th Cir. 1976). The

question of whether property is held primarily for sale to

customers in the ordinary course of a taxpayer’s business begins

with a factual analysis. Pritchett v. Commissioner, 63 T.C. 149,
 - 9 -

162 (1974); Raymond v. Commissioner, T.C. Memo. 2001-96 (citing

Cottle v. Commissioner, 89 T.C. 467, 487 (1987)).

Typically, the factors in making this determination include:

(1) The taxpayer’s purpose in acquiring the property; (2) the

purpose for which the property was subsequently held; (3) the

taxpayer’s everyday business and the relationship of the income

from the property to the total income; (4) the frequency,

continuity, and substantiality of sales of property; (5) the

extent of developing and improving the property to increase the

sales revenue; (6) the extent to which the taxpayer used

advertising, promotion, or other activities to increase sales;

(7) the use of a business office for the sale of property; (8)

the character and degree of supervision or control the taxpayer

exercised over any representative selling the property; and (9)

the time and effort the taxpayer habitually devoted to the sales.

Biedenharn Realty Co. v. United States, supra at 415; United

States v. Winthrop, 417 F.2d 905, 910 (5th Cir. 1969). The Court

of Appeals for the Fifth Circuit elaborated that frequency is

especially probative because “the presence of frequent sales

ordinarily belies the contention that property is being held ‘for

investment’ rather than ‘for sale.’” Suburban Realty Co. v.

United States, 615 F.2d 171, 178 (5th Cir. 1980).
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2. Analysis

We first examine petitioners’ purpose for acquiring and

holding the properties. Petitioner husband testified that sales

of the acquired properties resulted from a difficult market and a

desire for immediate funds. The record demonstrates that

petitioners purchased and sold real estate with the purpose of

receiving the maximum gain within a short period. None of the

alleged investment properties were leased and only one was held

for more than 1 year before being sold. These real estate

transactions were entered into regularly and resulted in

significant gains during the 3 years at issue. We find that the

overall purpose of acquiring the properties was to benefit from

the immediate financial gains in selling them as quickly as

possible.

Although petitioner husband was employed as a mortgage

banker during these years, this employment was secondary to the

real estate transactions he and his wife pursued. Petitioners’

earnings from the real estate transactions constituted their

primary source of income.

We also consider the frequency, continuity, and

substantiality of petitioners’ property sales. See Rice v.

Commissioner, T.C. Memo. 2009-142. Petitioners engaged in at

least 15 sales over 3 years, and most of the sales occurred

within 4 months after they purchased the property.
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Petitioner husband testified: “I’m in the business of

buying material, fixing houses and reselling them.” This

undertaking involved procuring insurance before the title

transfer in order to accelerate the resale. Petitioners did not

hold properties as an investment and did not rely on the services

of a real estate agent or another third party to select, promote,

or sell their properties.

Petitioners’ real estate transactions were conducted in the

ordinary course of a trade or business and not for investment

purposes. Accordingly, we find that respondent correctly treated

petitioners’ real estate activities as giving rise to ordinary

income derived from a trade or business.

3. Self-Employment Tax and Deduction

Section 1401(a) and (b) imposes a tax on the net earnings

from self-employment derived from any trade or business carried

on by the taxpayer. Sec. 1.1401-1(a), Income Tax Regs. The term

“trade or business” has the same meaning under section 1402(a),

defining “net earnings from self-employment”, as under section

162. Petitioners were engaged in the trade or business of

purchasing and selling real property during the years at issue.

On the basis of our finding that petitioners earned income in

their real estate trade or business, they are subject to tax on

their net earnings under section 1401 and to a deduction under

section 164(f).
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4. Adjustment of the Cost of Goods Sold

Section 6001 requires a taxpayer to keep records or render

statements sufficient to establish his gross income, deductions,

and credits. Sec. 1.6001-1(a), Income Tax Regs. The income of a

sole proprietorship must be included in calculating the income

and tax liabilities of the individual owning the business. Sec.

61(a)(2).

Respondent argues that petitioners were in the business of

renovating properties. Respondent describes petitioners’ regular

business activity as finding, purchasing, renovating, and selling

foreclosed properties, and respondent allowed expenses for

settlement and purchase costs. Petitioner husband explained that

the renovation process required procuring insurance, purchasing

materials, and hiring additional labor to assist with the repairs

and improvements. Notwithstanding the description of these

activities, petitioners failed to produce any receipts or other

reliable basis for fixing the amounts of repairs or other

expenditures incurred during their renovation activities. We

therefore find that we cannot approximate allowable amounts for

petitioners’ reported repairs and expenditures because

petitioners provided nothing on which we could rationally base an

estimate. However, to the extent respondent seeks additional

deficiencies, respondent has not shown that petitioners actually

realized net gains from sales of real estate as asserted in his
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amended answer, and we do not uphold the increased deficiencies

sought for 1998. We note that on brief respondent asserts

smaller amounts of gains and self-employment income than in the

notice of deficiency for 1999 and 2000.

B. Miscellaneous Issues

1. Dividend Income

Under section 61(a), gross income means all income from

whatever source derived including dividends. Sec. 61(a)(7).

During tax years 1998, 1999, and 2000, petitioners received

dividends of $38, $38, and $37, respectively, from their stock in

AT&T. Petitioners introduced no evidence to contradict these

adjustments, and, accordingly, respondent’s determination will be

sustained.

2. Interest Income

Under section 61(a)(4), gross income includes interest. For

tax year 1998, petitioners reported no interest income.

Petitioners introduced no evidence to contradict respondent’s

determination that they received interest income in 1998.

Petitioners have not met their burden, and respondent’s

determination is sustained.

3. Itemized Deduction

Petitioners claimed various itemized deductions including

taxes, mortgage interest, charitable contributions, dependency

exemption deductions, and the child tax credit. Respondent
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allowed mortgage interest expenses for years 1998-2000 but

adjusted petitioners’ dependency exemption deductions, itemized

deductions, and child tax credit. Petitioners’ entitlement to

other itemized deductions for each year was automatically

adjusted on the basis of respondent’s calculations of their

adjusted gross income. Petitioners failed to produce receipts,

expense reports, or other records indicating that they qualified

for deductions in excess of the amounts respondent allowed, and

petitioners are not entitled to additional deductions.

C. Section 6651(a)(1) Addition to Tax

Section 6651(a)(1) imposes an addition to tax equal to 5

percent of the amount required to be shown as tax on the return.

An additional 5 percent is imposed for each additional month or

fraction thereof during which the failure to file continues, but

not to exceed 25 percent in the aggregate. Id. Under section

7491(c), the Commissioner must come forward with sufficient

evidence to show that an addition to tax is appropriate but need

not introduce evidence regarding reasonable cause or similar

provisions. Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

The burden of proof for the amounts included in the notice of

deficiency with respect to the additions to tax remains on

petitioners.

This addition to tax may be avoided if the failure to file

timely was due to reasonable cause and not willful neglect.
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United States v. Boyle, 469 U.S. 241, 245-246 (1985). Reasonable

cause exists for late filing if the taxpayer exercised ordinary

care and prudence but was nevertheless unable to file on time.

Sec. 301.6651-1(c)(1), Proced. & Admin. Regs.

Petitioners filed their 1998, 1999, and 2000 Federal income

tax returns in 2002. Petitioner husband acknowledged this error

at trial and stated he had no excuse to explain the delayed

filing. Petitioners did not show reasonable cause or otherwise

indicate that the delay resulted from something other than

neglect resulting in a failure to comply with filing

requirements. We therefore find petitioners did not have

reasonable cause and are liable for the section 6651(a)(1)

addition to tax for failure to file timely for each year at

issue.

III. Conclusion

Petitioners regularly purchased and sold real estate

properties in the ordinary course of their trade or business and

are thus liable for the adjustment to their gross income and

self-employment taxes. Respondent’s assertion of increased

deficiencies and additions to tax based on the inclusion of

income in 1998 in excess of the amounts determined in the notice

of deficiency fails because respondent has not established that

the increased sales were not offset by costs petitioners asserted

at trial. Thus, to the extent that respondent increased the
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amount of income for real property sales during 1998 over the

amounts determined in the notice of deficiency, petitioners are

not liable for either the increased deficiency or the increased

addition to tax. On brief respondent conceded some amounts of

self-employment income from real estate sales for 1999 and 2000,

and these concessions as listed in the Findings of Fact are

accepted. Concerning petitioners’ request for additional expense

deductions in 1998, 1999, and 2000, petitioners have not met

their burden to establish that they qualify for additional

deductions in excess of those allowed. Petitioners are liable

for the section 6651(a)(1) additions to tax for 1998, 1999, and

2000 resulting from the above analysis.

To reflect the foregoing,

Decisions will be entered

under Rule 155.