T.C. Summary Opinion 2011-22
UNITED STATES TAX COURT
TODD D. BAILEY, JR. AND PAMELA J. BAILEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 28706-09S. Filed March 2, 2011.
Kurt C. Swainston, for petitioners.
Eugene Kim, 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.
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
- 2 -
Revenue Code (Code) in effect for the year in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
Respondent determined a $19,358 deficiency in petitioners’
Federal income tax for 2004. After stipulation, the sole issue
for decision is whether for 2004 petitioners are entitled to
deduct a net loss of $16,822 from two single-family rental
properties that they owned.
Background
I. General Background
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. Petitioners resided in
California at the time the petition was filed. Petitioner
husband worked as an emergency physician during 2004. His income
and deductions are not at issue except to the extent that his
2004 earnings of $212,200 caused the couple to encounter an
itemized deduction phaseout with respect to their 2004 Federal
income tax return.
During 2004 petitioner wife (petitioner) did not earn a
salary. Instead, she operated three rental properties that the
couple owned jointly. Petitioner’s father was a builder. Her
mother worked with her father as a bookkeeper and an interior
decorator. This upbringing gave petitioner an “eye” for the
housing market, and experience with building codes, architectural
- 3 -
plans, and subcontractors. Beginning around 1980 and using
mortgage financing and joint funds with petitioner husband,
petitioner continuously was in the market to purchase property
with potential for either resale or conversion into income-
producing property.
Following this pattern, during 2004 petitioner negotiated
the purchase of a fourth single-family rental property and
researched a number of other potential single-family rental
property acquisitions. Below is a detailed description of
petitioner’s rental real estate activities for 2004. Petitioner
husband did not participate in the rental activities during the
year.
II. Petitioner’s Rental Real Estate Activities for 2004
A. The Inn on Alisal Road
1. Description of the Property
One of petitioners’ rental properties was on Alisal Road,
about 6 or 7 miles from the couple’s home. They purchased the
property in 2000. The structures consisted of a 1,200-square-
foot, two-bedroom, 3/4-bath (no tub) front house, built in 1949
or 1950, and a smaller back unit that had been converted from a
one-car garage into a separate residential dwelling.
- 4 -
Petitioner named this combined property “The Inn on Alisal
Road” (Inn). As the name indicates, petitioner furnished the two
units and offered them together or separately for short-term rent
to overnight lodgers, usually for about 3 days at a time.
Petitioner provided a coffeemaker and coffee, but guests were
responsible for their own meals. Typical guests were repeat
customers, most often couples or small groups, who were in town
for a wedding or other special occasion. Petitioner rented the
Inn for 48 nights in 2004, with no guests in January and
February. June was the most active month with guests on 12
nights. Petitioner usually charged $200 or $250 per night. She
did not record the guest names in a bookkeeping journal she
maintained in which she listed her receipts for the Inn by date
for 2004.
2. Petitioner’s Activities
Petitioner did not employ a management company. Instead,
she operated the Inn herself.
Petitioner’s onsite tasks included meeting potential guests
and cleaning the interior: Dusting, vacuuming, washing sheets,
ironing, and running water to maintain the plumbing during
periods when the Inn was inactive. Petitioner also maintained
the exterior, including gardening, hand watering the roses,
caring for a plum tree and two cherry trees, inspecting the water
drip irrigation system, taking out trash, reviewing the work of a
- 5 -
lawn service, and periodically cleaning leaves out of the
gutters. On average during 2004, for the two units combined,
petitioner spent 5 hours per week on the interior and exterior
maintenance of the Inn, for a total of 260 hours for the year.1
Petitioner also worked offsite with respect to the Inn. She
would deposit guest payments at her bank. She received telephone
calls inquiring about the Inn and calls for reservations. She
paid bills and reconciled the bank account. On occasion, she
would wash and iron the Inn’s linens in her large-capacity washer
and dryer at home. She went to hardware and home improvement
stores to buy replacement items, such as light bulbs, a new
showerhead, and a new telephone. On average, she spent 5 hours
1
For reasons explained in the discussion section below, the
number of hours petitioner spent on her rental property
activities is an important factor in the outcome of this case.
Petitioner did not maintain a log for 2004. The regulations do
not allow a postevent “ballpark guesstimate”. Hill v.
Commissioner, T.C. Memo. 2010-200; Carlstedt v. Commissioner,
T.C. Memo. 1997-331; Speer v. Commissioner, T.C. Memo. 1996-323;
Goshorn v. Commissioner, T.C. Memo. 1993-578. A log is not
required, however, and an individual may establish the extent of
participation in an activity by any reasonable means. Hill v.
Commissioner, supra; sec. 1.469-5T(f)(4), Temporary Income Tax
Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). In support of
petitioner’s testimony, the Court received into evidence lease
agreements, mortgage and closing agreements, attorney time
records, litigation documents, copies of correspondence, rental
car and airline receipts, third-party confirmation from a real
estate agent, photographs, and other corroborating documents.
Respondent did not challenge the time estimates for particular
tasks. Accordingly, we base our findings for hours on this
evidence, which was credible, even seemingly understated at
points, but bearing against petitioner for inexactitudes of her
own making. See Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir.
1930).
- 6 -
per month offsite related to the Inn, for a total of 60 hours for
the year.
Petitioner spent 4 hours during the year refinancing the
property. She secured a variable-rate equity loan of $220,250,
initially at 5.640 percent. She used the proceeds in main part
to extinguish a 10-percent fixed rate seller-financed mortgage.
3. Summary of Time Spent
Below is a summary of petitioner’s hours with respect to the
Inn.
Activity Hours
Interior and exterior maintenance 260
Offsite supply purchases and banking 60
Refinancing the mortgage 4
Total for the Inn 324
4. Profitability
For the year, petitioner incurred a net loss on the Inn of
$20,683. The loss consisted of $10,680 in guest receipts offset
by $31,363 in expenses. Interest payments on first and second
mortgages, depreciation, and property taxes were her largest
expenses.
B. The Second Street Property
1. Description of the Property
A second of petitioners’ rental properties was on Second
Street (Second Street property), about two blocks from the Inn.
Petitioners purchased the property in 2000 for $292,000. Similar
to the Inn, the property included two structures. The front unit
- 7 -
was a 1,149-square-foot, three-bedroom home, with 1-3/4 baths.
The back unit was a one-car garage that petitioner converted in
2002 into a small residence with a three-quarter bath and a
kitchenette.
2. Petitioner’s Activities
As with the Inn, petitioner managed the Second Street
property personally and did not employ a management company. In
contrast to the short-term guests at the Inn, petitioner sought
year-to-year tenants for the Second Street units.
a. Both Units
Because petitioner sought long-term tenants, she did not
have interior duties at the Second Street property to the extent
she had with the Inn. Her exterior responsibilities, however,
were similar, including testing the water drip irrigation system,
gardening, caring for an apricot tree and a large oak tree, and
reviewing the work of a lawn service. She spent 3 hours a week
on exterior maintenance for a total of 156 hours for the year.
Petitioner had routine offsite financial recordkeeping
duties similar to those with the Inn. She would spend 3 hours a
month depositing the monthly rent payment at her bank, paying
bills from her home, and reconciling the bank account, for a
total of 36 hours for the year.
- 8 -
b. Back Dwelling
During 2004 petitioner rented the back unit for $1,100 per
month. Her tenant had continued the lease from 2003 but did not
renew in 2004 after a sewer backup problem. Petitioner spent a
total of 20 hours during the year overseeing a plumbing
contractor to correct the problem and cleaning the unit. Within
2 months, petitioner was able to find a new tenant for the same
$1,100 monthly rent. She spent 10 hours during 2004 searching
for the new tenant, showing the unit, and executing the new lease
agreement.
c. Front Dwelling
Unusual circumstances with respect to the front unit caused
petitioner to spend extra time with respect to the Second Street
property during 2004. By late 2000 petitioner’s tenants in the
front house noticed a mildew problem. The tenants moved out.
They turned out to be petitioner’s last tenants in the front
unit. As petitioner began stripping away layers of linoleum to
determine the extent of the mildew problem, she discovered that
black mold was present throughout the entire underpinning of the
home. By the end of 2001 petitioner was “at wits’ end”. She
eventually discovered that an earlier inspector had determined
that the home has insufficient subvents. In addition, a prior
owner built an addition that blocked some of the existing
subvents. Further, the El Nino storm of 1997-98 soaked the
- 9 -
carpets, flooring, and walls, compounding the problem. The toxic
mold infestation was so bad that petitioner was unable to provide
a warranty of habitability to any prospective tenant.
In 2002 petitioners engaged an attorney to sue the prior
owner and the owner’s son-in-law. The son-in-law served as the
agent for the seller (his mother-in-law) and for the buyer
(petitioners). Petitioners claimed in main part that the prior
owner and the son-in-law knew about the mold problem and did not
tell them. Petitioners also named as defendants a business that
performed the home inspection for their purchase and a pest
control contractor that petitioner paid annually to inspect the
home for termites.
During 2003 petitioner learned that even if they won the
case, they might not be able to collect the judgment if the
defendants did not have sufficient assets. Petitioner hired a
private investigator to search for assets. During 2004,
petitioner spent 30 hours conducting Internet research to assist
the private investigator.
Petitioner paid her attorney $70,109 during 2004 for his
work on the lawsuit. During the year, petitioner spent 15 hours
periodically discussing the litigation with the attorney and
reviewing documents that he sent to her. She also spent 5 hours
coordinating with the attorney to determine whether the
- 10 -
homeowner’s policy covered any part of the loss. The insurance
company denied coverage.
In 2004 the pest control contractor settled its liability
for $50,000. The home inspection business also settled, but the
settlement amount is not in the record. Following a nonjury
trial in January 2005, the Superior Court of the State of
California, County of Santa Barbara, awarded petitioners
$135,303.81 in damages from the prior owner for “breach of
contract” and the same amount in damages from the prior owner’s
son-in-law for “professional negligence”. In addition, the court
awarded petitioners recovery of attorney’s fees and costs.
Petitioner spent further time in 2004 on other activities
related to the front unit. First, because the home was vacant,
she would spend an hour per week in the interior cleaning,
dusting, and in maintaining the plumbing, for a total of 52 hours
for the year.
Second, she spent 24 hours in 2004 planning how she would
renovate the home after she received the litigation proceeds and
after contractors finished gutting the interior to remove the
mold and to install proper venting. She met with representatives
of the town’s building department, and she drafted plans to
redesign the interior. For example, she decided to remove a wall
between the kitchen and the dining room to create an open floor
plan.
- 11 -
Third, petitioner spent 10 hours during the year driving to
hardware and paint stores to buy supplies and working with movers
to bring items from storage to the property.
3. Summary of Time Spent
The following is a summary of petitioner’s hours for 2004
with respect to her activities for the Second Street property.
Combined for Both Units Hours
Exterior maintenance 156
Offsite bill paying and banking 36
Subtotal 192
Back Unit Only Hours
Correct and clean sewer backup 20
Search and lease for new tenant 10
Subtotal 30
Front Unit Only Hours
Asset investigation research 30
Litigation monitoring and support 15
Insurance coverage inquiries 5
Interior maintenance 52
Renovation planning 24
Supplies purchases and movers 10
Subtotal 136
Grand total for the Second St. property 358
4. Profitability
Petitioner incurred an operating loss of $17,167 related to
the Second Street property for 2004. The loss consisted of
$11,000 in rent she collected on the back unit minus $28,167 in
operating expenses related to both units. Mortgage interest,
depreciation, supplies, and property taxes were the largest
- 12 -
expenses. As noted above, petitioner also expended $70,109 in
2004 for attorney’s fees related to the mold litigation for the
front unit.
C. The Existing Boise Property
1. Description of the Property
The third of petitioners’ rental properties was on Rose Hill
Street, Boise, Idaho (existing Boise property). Petitioner
became interested in Boise because she found that she liked the
area from visiting a brother living there and a great uncle who
lived nearby. The record is sparse about this property, other
than that it was a single-family home that petitioner purchased
in an earlier year and which one tenant or family rented for all
of 2004.
2. Petitioner’s Activities
Petitioner operated the existing Boise property directly and
did not employ a management company. For 2004 petitioner’s
duties consisted solely of spending 2 hours per month, for a
total of 24 hours for the year, depositing to her bank account
the monthly rent check she received by mail, paying from her home
occasional bills such as the annual water bill and a one-time
special sewer connection charge, and reconciling the bank
account. No extraordinary events occurred during 2004 that
required additional time.
- 13 -
3. Summary of Time Spent
Activity Hours
Bill paying and banking 24
Total for existing Boise property 24
4. Profitability
Petitioner earned a profit of $345 related to the existing
Boise property for 2004. The profit consisted of $6,000 in rent
she received minus $5,655 in expenses. Mortgage interest,
property taxes, and depreciation were the largest expenses.
D. New Acquisition in Boise
1. Description of Property
On August 25, 2004, petitioner paid $185,000 to acquire
another one-story single-family home in Boise, on a 3/4-acre lot,
also located on Rose Hill Drive (new acquisition in Boise). She
financed the purchase with a $166,315 mortgage and joint funds.
The house, built in 1941, is a “darling” home with a wood burning
fireplace, crown molding, and a brick exterior made with “clinker
bricks”. The main floor contains two bedrooms, one bathroom, and
a small kitchen. Prior owners had converted the basement into an
apartment for a person who took care of the owner. Petitioner
did not begin renting the home to tenants in 2004.
2. Petitioner’s Activities
Petitioner first found the new acquisition in Boise in April
2004 on the Internet. She researched the property online before
contacting the seller’s real estate agent. After a week of
- 14 -
telephone discussions and emails with the agent, petitioner made
a formal offer for the property. Her total time through
extending the offer was 10 hours.
The 20 weeks from her escrow deposit to closing was
unusually time consuming for petitioner because she had not
previously purchased a home from a “short sale”. Petitioner’s
questions about zoning and the purchase difficulties caused her
to speak weekly with the selling realtor. These discussions
totaled 2.5 hours per week for a sum of 50 hours over the 20-week
escrow period.
Petitioner also made numerous calls to representatives of
the seller’s bank, which was controlling the sale. In addition,
petitioner spoke a number of times with a Boise representative of
her own bank regarding mortgage terms. Her discussions with
bankers totaled 10 hours during the year.
Petitioner flew round trip to Boise on August 11, 2004, for
a walkthrough inspection of the house before closing. She left
her home around 5:15 a.m., drove to the Los Angeles airport
(LAX), flew to Boise, rented a car, completed the inspection,
returned to the Boise airport, dropped off the rental car, flew
back to LAX, and arrived at about 8:15 p.m. at the LAX parking
lot. She drove to her parents’ home nearby for the night,
returning to her own home the next morning. In combination with
- 15 -
making airline and rental car reservations, petitioner devoted 25
hours to inspecting the new acquisition in Boise.
Petitioner also spent 10 hours related to the closing
agreement and to planning future remodeling of the property.
3. Summary of Time Spent
Activity Hours
Pre-offer research, emails, and calls 10
Discussions with realtor during escrow 50
Discussions with banker 10
Round-trip to Boise for walkthrough 25
Closing and renovation planning 10
Grand total for new acquisition in Boise 105
4. Profitability
Petitioner did not have income and did not report her
expenses related to the new acquisition in Boise for 2004.
E. Research of Other Potential Acquisitions
1. Description of Property
Petitioner researched other properties for potential
acquisition in certain real estate markets that she found
promising. She particularly focused on houses in Boise; the
Brentwood section of Los Angeles; San Fernando Valley,
California; Santa Ynez Valley, California; and Sherman Oaks,
California.
2. Petitioner’s Activities
Petitioner conducted her research on potential acquisitions
primarily over the Internet. She would peruse real estate Web
sites. During 2004, on 3 days each week petitioner spent an hour
- 16 -
conducting her Internet research, totaling 156 hours for the
year. For locations nearby she would drive through the areas to
assess houses and the local market. Her monthly research drives
through neighborhoods would take 3 hours for a total of 36 hours
for the year.
3. Summary of Time Spent
Activity Hours
Internet research 156
Driving investigation of neighborhoods 36
Grand total for research of other
potential acquisitions 192
4. Profitability
Petitioner did not receive any income and did not keep
records of the expenses related to her investigation of potential
property purchases in 2004.
III. Summary of Petitioner’s Time With Respect to All of the
Rental Income Properties for 2004
Below is a summary of the time petitioner spent with respect
to all of her rental income properties for 2004.
Activity Hours
The Inn on Alisal Road 324
The Second Street property 358
The existing Boise property 24
The new acquisition in Boise 105
Researching potential acquisitions 192
Grand total for all properties 1,003
Less time spent on the Inn (see below) (324)
Total hours excluding the Inn 679
- 17 -
IV. Procedural Posture
Petitioners engaged Benadon, Shapiro, Villalobos, C.P.A.s,
of Burbank, California, to prepare their 2004 Federal income tax
return. Although the return encompassed 39 pages, relevant here
are solely two items: (1) Petitioners deducted a loss of $20,683
from the Inn, which they reported on Schedule C, Profit or Loss
From Business; and (2) petitioners deducted a loss of $86,931
from the other two rental properties, which they reported on
Schedule E, Supplemental Income and Loss. The Schedule E loss
consisted of three components: (1) The $17,167 operating loss on
the Second Street property; (2) the $70,109 in attorney’s fees
for the Second Street property; and (3) the $345 profit on the
existing Boise property. Petitioners did not report any income
or expenses related to the new acquisition in Boise or from
petitioner’s general research into other potential real estate
acquisitions.
Respondent selected petitioners’ 2004 Federal income tax
return for examination. Respondent allowed the $20,683 Schedule
C loss for the Inn. In a notice of deficiency, however,
respondent disallowed the $70,109 in attorney’s fees related to
the Second Street property, determining that the fees were not a
currently deductible ordinary and necessary business expense.
Respondent also disallowed the remaining Schedule E loss of
$16,822, consisting of the $17,167 loss on the Second Street
- 18 -
property offset by the $345 profit on the existing Boise
property. Respondent determined that the $16,822 net loss was a
passive activity loss that was not currently deductible for 2004.
The disallowances caused an increase to petitioners’
adjusted gross income (AGI), which in turn caused a computational
phaseout of $1,466 of their itemized deductions. The adjustments
and phaseout resulted in a Federal income tax deficiency of
$19,358 for 2004.
Petitioners contested the adjustments in a petition to this
Court. The parties stipulated that the $70,109 in attorney’s
fees was a capital expenditure that petitioners should add to the
basis of the Second Street property. The stipulation left as the
sole disputed issue whether petitioners may deduct the remaining
Schedule E net loss of $16,822.
Discussion
I. Burden of Proof
In general, the Commissioner’s determination set forth in a
notice of deficiency is presumed correct, and the taxpayer bears
the burden of showing that the determination is in error. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Deductions
are a matter of legislative grace. Deputy v. du Pont, 308 U.S.
488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435,
440 (1934). A taxpayer bears the burden of proving entitlement
to any deduction claimed. Rule 142(a); INDOPCO, Inc. v.
- 19 -
Commissioner, 503 U.S. 79, 84 (1992); Welch v. Helvering, supra;
Wilson v. Commissioner, T.C. Memo. 2001-139.
Pursuant to section 7491(a), the burden of proof as to
factual matters shifts to the Commissioner under certain
circumstances. Petitioners have neither alleged that section
7491(a) applies nor established their compliance with the
substantiation and recordkeeping requirements. See sec.
7491(a)(2)(A) and (B). Petitioners therefore bear the burden of
proof. See Rule 142(a).
II. Passive Losses in General
Taxpayers may deduct ordinary and necessary expenses they
paid or incurred during the year in carrying on a trade or
business and for the production of income. Secs. 162, 212. The
Code, however, limits the deduction for losses arising from a
“passive activity”. Sec. 469(a).
A passive activity is any trade or business in which the
taxpayer does not materially participate. Sec. 469(c)(1). A
passive activity loss is the excess of the aggregate losses from
all passive activities for the year over the aggregate income
from all passive activities for that year. Sec. 469(d)(1). A
rental activity is generally treated as a per se passive activity
regardless of whether the taxpayer materially participates. Sec.
469(c)(2). A rental activity is “any activity where payments are
principally for the use of tangible property.” Sec. 469(j)(8).
- 20 -
III. Real Estate Professional
A. Exceptions to the General Rule
There are two main exceptions to the general rule that
rental activities are per se passive activities. Moss v.
Commissioner, 135 T.C. __, __ (2010) (slip op. at 6). One
exception applies to rental real estate activities where the
individual actively participates in the activity during the year.
Sec. 469(i)(1); Moss v. Commissioner, supra at __ (slip op. at
10). The maximum deductible loss under this first exception is
$25,000. Sec. 469(i)(2). The $25,000 loss allowance, however,
begins to phase out when AGI exceeds $100,000 and phases out
completely when AGI is $150,000 or more. Sec. 469(i)(3)(A); Moss
v. Commissioner, supra at __ (slip op. at 10). The stipulation
to capitalize the $70,109 in attorney’s fees increased
petitioners’ AGI from their reported figure of $104,637 to an
amount exceeding the $150,000 phaseout ceiling. Consequently,
the active participation exception is not available to
petitioners.
The other exception is the one in controversy here. This
second exception is available to “taxpayers in real property
business” (real estate professionals). Sec. 469(c)(7). Rental
activities of a real estate professional are not per se passive
activities under section 469(c)(2). Sec. 469(c)(7)(A)(i); Moss
- 21 -
v. Commissioner, supra at (slip op. at 6); sec. 1.469-9(e)(1),
Income Tax Regs.
To qualify as a real estate professional, a taxpayer must
satisfy both of the following requirements:
(i) more than one-half of the personal services
performed in trades or businesses by the taxpayer
during such taxable year are performed in real property
trades or businesses in which the taxpayer materially
participates, and
(ii) such 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). For couples filing “a joint return, the
requirements of the preceding sentence are satisfied if and only
if either spouse separately satisfies such requirements.” Id.
In other words, only one spouse needs to qualify as a real estate
professional to recharacterize an otherwise passive activity.
Moss v. Commissioner, supra at (slip op. at 6-7).
B. Application of the 750-Hour Requirement to Petitioner
Respondent does not dispute that petitioner satisfied the
first requirement of materially participating in the activities.
Among other qualifying factors, petitioner had no other vocation
during 2004 and her involvement in the properties was regular,
continuous, and substantial. See sec. 469(h)(1); sec 1.469-
5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25,
1988). Therefore, the only remaining issue is whether petitioner
- 22 -
performed more than 750 hours of services in “real property
trades or businesses” during 2004.
To compute the 750 hours, the Code treats each real estate
activity as a separate activity unless the taxpayer makes an
election to combine some or all of the activities. Sec.
469(c)(7)(A); Hill v. Commissioner, T.C. Memo. 2010-200; sec.
1.469-9(e)(1), Income Tax Regs. An election is binding for the
year of election and for all future years in which the taxpayer
qualifies. Sec. 1.469-9(g), Income Tax Regs. Respondent does
not contend that petitioners failed to elect to combine all of
their rental properties as one activity. Accordingly, we deem
that issue conceded. See Moss v. Commissioner, supra at __ (slip
op. at 7).
Respondent does contend, however, that the Inn is not a
“real property trade or business” for purposes of the 750-hour
test. The significance of respondent’s contention is that if
petitioner can include the hours she spent on the Inn, then she
easily satisfies the 750-hour requirement because she spent 1,003
hours on all of her rental activities for the year. If, on the
other hand, she cannot include the hours relating to the Inn,
then she spent only 679 hours on her real estate activities. See
table supra p. 16. She would not satisfy the 750-hour
requirement, she would not qualify as a real estate professional,
the two rental properties at issue would be per se passive
- 23 -
activities, and as a result the $16,822 net loss would not be
deductible in 2004.
C. The Parties’ Contentions
Petitioner points to the plain language of section
469(c)(7)(C) and its legislative history2 to contend that
congressional intent and the statute itself clearly allow her to
include her hours from her activities for the Inn. The statute
describes a “real property trade or business” as “any real
property development, redevelopment, construction,
reconstruction, acquisition, conversion, rental, operation,
management, leasing, or brokerage trade or business.” Id.
(emphasis added by petitioner).
Respondent counters by pointing to a regulation that
provides the following exclusion: “an activity involving the use
of tangible property is not a rental activity” for a year if,
among other reasons, “the average period of customer use for such
property is seven days or less” during the year. Sec.
1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs., 53 Fed. Reg.
5702 (Feb. 25, 1988). The parties agree that the average period
of the guests’ use of the Inn in 2004 was 3 days. Therefore,
respondent contends that for passive activity purposes for 2004,
petitioner must separate the hours spent on and the loss from the
2
Petitioner refers to H. Rept. 103-111, at 613-614 (1993),
1993-3 C.B. 167, 189-190.
- 24 -
Inn from her other rental real estate activities hours and net
loss.
D. The Court’s Prior Opinion in Bailey
To support his position, respondent points to an opinion of
this Court, Bailey v. Commissioner, T.C. Memo. 2001-296 (no
relation to petitioners), which involved a similar set of facts.
Because petitioner also focuses on the Bailey opinion, we detail
below the facts and holding of that case.
In Bailey the taxpayers, husband and wife, were licensed
attorneys. In 1997, the pertinent year at issue, they also owned
and taxpayer wife (taxpayer) participated in the operation of
five real estate properties at three locations: (1) The Lake
Arrowhead property (a single-family house); (2) the Indian Wells
properties (a condominium and a unit in a planned development);
and (3) the Elderwood properties (two four-plex buildings). The
taxpayer also spent 104 hours on general real estate activities
not associated with any one particular property. The taxpayer
rented the Lake Arrowhead property to customers in 1997 for
periods averaging less than 4 days.
The taxpayers had made a previous election to group the
properties as one activity. Each of the properties generated a
loss for 1997. The taxpayers combined them and deducted the
losses on Schedule E of their 1997 Federal income tax return.
- 25 -
The Commissioner determined that the taxpayer could not
combine her hours on the Lake Arrowhead property with her hours
on the other two rental properties because the rental period for
the Lake Arrowhead property was less than the 7-day threshold of
section 1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs., supra.
Accordingly, the Commissioner disallowed the taxpayers’ losses
from all three of their rental properties.
Specifically with respect to disallowing the loss from the
Lake Arrowhead property, the Commissioner determined that the
taxpayer did not establish that she materially participated in
operating the property in part because she engaged a management
company to operate the property and in part because she had
significant outside activities as an attorney. Pertinent here,
the Commissioner also disallowed the losses on the taxpayer’s
other two rental properties because the taxpayer did not
establish that she expended more than 750 hours of personal
services on these other two properties, including her time on
general rental real estate activities but excluding her time on
the Lake Arrowhead property.
The taxpayer contended that she qualified as a real estate
professional for 1997 because when she included the Lake
Arrowhead property, she met the two requirements of section
469(c)(7)(B); namely: (1) She performed more than one-half of
her personal services for the year in real property trades or
- 26 -
businesses; and (2) she performed more than 750 hours in real
property trades or businesses in which she materially
participated. Therefore, according to the taxpayer, she and her
husband were entitled to deduct the losses from all of their
rental properties because she was a real estate professional for
the year.
The Court sustained the Commissioner’s disallowance of all
of the taxpayers’ rental real estate losses for 1997 because:
(1) The taxpayer did not materially participate in the Lake
Arrowhead property; and (2) relevant here, after excluding the
taxpayer’s time on the Lake Arrowhead property because of its
short--less than 7 days--average rental period, the taxpayer did
not have more than 750 hours in personal services on the other
properties to qualify as a real estate professional. In summary,
the short rental period made the Lake Arrowhead property a trade
or business, not a rental real estate activity.
E. Applying Bailey to Petitioner’s Facts and Circumstances
Petitioner distinguishes her facts and circumstances from
those of the taxpayer in Bailey. Petitioner emphasizes that she
materially participated in the operation of the Inn, a point with
which respondent agrees, whereas the taxpayer in Bailey did not
materially participate in the operation of the Lake Arrowhead
property. From petitioner’s viewpoint, her material
participation in the Inn in 2004, in combination with the clear
- 27 -
and unambiguous plain language of section 469(c)(7)(C), requires
the inclusion of the hours she spent operating the Inn for
purposes of the 750-hour test. In other words, petitioner
contends that a taxpayer is entitled to include all real property
trades or businesses in which the taxpayer materially
participated during the year for purposes of computing the 750-
hour requirement for a real estate professional. We disagree.
The Court in Bailey addressed this exact issue, in two
portions of the opinion. We quote extensively below from Bailey
to resolve any doubt. The first excerpt below comes from the
portion of the opinion where the Court was deciding whether the
taxpayer met the 750-hour test to be a real estate professional,
as follows:
Whether petitioner qualifies as a real estate
professional under section 469(c)(7) is based on
petitioner’s activities related to the Indian Wells
condominium, Indian Wells unit, and Elderwood
properties. Petitioners argue that the Lake Arrowhead
property is rental real estate that should be included
in determining whether petitioner is a real estate
professional. We disagree.
Petitioner’s activities that are related to the
Lake Arrowhead property are disregarded for purposes of
determining whether she was a real estate professional,
because the Lake Arrowhead property is not “rental real
estate” as defined in section 1.469-9(b)(3), Income Tax
Regs. Section 1.469-9(b)(3), Income Tax Regs., defines
“rental real estate” as “any real property used by
customers or held for use by customers in a rental
activity within the meaning of section 1.469-1T(e)(3).”
Section 1.469-1T(e)(3), Temporary Income Tax Regs., 53
Fed. Reg. 5702 (Feb. 25, 1988), states that, except as
otherwise provided, an activity is a “rental activity”
for a taxable year, if “during such taxable year,
- 28 -
tangible property held in connection with the activity
is used by customers or held for use by customers”.
See also sec. 469(j)(8). As provided in section
1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs.,
supra, an “activity involving the use of tangible
property is not a rental activity for a taxable year if
for such taxable year * * * [the] average period of
customer use for such property is seven days or less”.
The average period of customer use for the Lake
Arrowhead property was less than 7 days during 1996 and
1997. Thus, the rental of the Lake Arrowhead property
is not a “rental activity” as defined in section
1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs.,
supra, not “rental real estate” under section
1.469-9(b)(3), Income Tax Regs., and not included in
the election under section 469(c)(7) to treat all
interests in rental real estate as a single rental real
estate activity. See Scheiner v. Commissioner, T.C.
Memo. 1996-554 (where average period of customer use
less than 7 days, condominium hotel activity was not
rental activity under section 469(j)(8) and not
considered a passive activity under section 469(c)(2));
Mordkin v. Commissioner, T.C. Memo. 1996-187.
Accordingly, petitioner’s attempt to distinguish her
situation because she materially participated in operating the
Inn is misplaced. Petitioner misapprehends the significance of
material participation. As noted supra p. 20, material
participation is significant for determining whether a trade or
business is a passive activity. For example, the taxpayer in
Bailey did not materially participate in operating the Lake
Arrowhead property. Consequently, because the Lake Arrowhead
activity was not a rental activity under section 469(c)(2), but
rather a trade or business in which the taxpayer did not
materially participate under section 469(c)(1), the Lake
Arrowhead activity was a passive activity; and therefore the
- 29 -
Commissioner disallowed the losses. As applied here, as noted
supra pp. 17-18, respondent allowed petitioner’s year 2004
Schedule C loss for the Inn because she materially participated
in the activity during the year.
The above excerpt from Bailey illustrates this point. When
a taxpayer spends time on a real estate property that the
taxpayer rents for periods averaging less than 7 days, that
property is no longer a “rental activity”. Therefore, the
taxpayer must exclude or “disregard” the time he or she spent on
the property for purposes of counting hours for the 750-hour
section 469(c)(7)(B)(ii) test to be a real estate professional.
Further, as if in anticipation of petitioner’s contentions,
the Court in Bailey, in a later portion of the opinion, stated
the following in discussing whether the taxpayer could separately
deduct the loss on the Lake Arrowhead property as a Schedule C
business loss:
Petitioners argue that they properly filed an
election pursuant to section 469(c)(7)(A)(ii) to treat
all of their interests in rental real estate as a
single rental real estate activity and that their
activities related to the rental of their Lake
Arrowhead property should be considered in aggregate
with their other rental properties. As previously
explained, petitioners’ argument fails because the
election to treat all rental properties as one activity
is limited to the purpose of determining whether a
taxpayer is a real estate professional under section
469(c)(7). Here, the average period of use of the Lake
Arrowhead property was less than 7 days in 1996 and
1997; thus, the rental of the Lake Arrowhead property
is not a rental activity as defined in section
469(j)(8) and is not a passive activity under section
- 30 -
469(c)(2). See Scheiner v. Commissioner, supra;
Mordkin v. Commissioner, supra. * * *
We reiterate the holding in Bailey that a rental property
with average use of less than 7 days is not an activity that a
taxpayer can include in computing the more than 750 hours of
services that a taxpayer needs to qualify as a real estate
professional under section 469(c)(7)(B)(ii).
The rationale for segregating petitioner’s hours is
consistent with the disparate reporting of the activities. The
Inn activity is reported on Schedule C because managing a
property with a short rental period is akin to running a
business. The other rental real estate activities are reported
on Schedule E as a separate and distinct activity and generally
fall within the purview of section 212.
The statute’s legislative history reinforces this rationale,
though not as petitioner suggests. A 1986 Senate Finance
Committee report, in explaining the then-new passive activity
loss rules, provided the following clarification: “A passive
activity is defined under the bill to include any rental
activity, whether or not the taxpayer materially participates.
However, operating a hotel or similar transient lodging, for
example, where substantial services are provided, is not a rental
activity.” S. Rept. 99-313, at 720 (1986), 1986-3 C.B. (Vol. 3)
1, 720.
- 31 -
IV. Conclusion
In summary, the 679 hours petitioner spent in 2004 on all of
her rental real estate activities excluding the Inn are not more
than the 750 hours that section 469(c)(7)(B)(ii) requires for
petitioner to qualify as a real estate professional.
Consequently, these other activities are per se passive under
section 469(c)(2). We therefore sustain respondent’s
disallowance for 2004 of petitioners’ combined net loss of
$16,822 from their Second Street property and their existing
Boise property.
We have considered all of petitioners’ contentions and
arguments that are not discussed herein, and we conclude they are
without merit, irrelevant, and/or moot.
To reflect the foregoing,
Decision will be entered
under Rule 155.