T.C. Summary Opinion 2012-91
UNITED STATES TAX COURT
FREDERICK T. CHAMBERS AND JANICE K. CHAMBERS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1093-10S. Filed September 12, 2012.
Frederick T. Chambers and Janice K. Chambers, pro se.
Ashley D. Money, for respondent.
SUMMARY OPINION
PARIS, 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.
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In a notice of deficiency dated December 15, 2009, respondent determined
deficiencies in petitioners’ joint Federal income tax of $5,433, $10,076, and $4,133
for 2005, 2006, and 2007, respectively. Respondent also determined section 66621
accuracy-related penalties of $1,086.60, $2,015.20, and $826.60 for 2005, 2006,
and 2007, respectively. After concessions by the parties,2 the issues for decision
are: (1) whether petitioners may deduct losses from their rental real estate activities
under the passive activity loss rules in section 469, and (2) whether they are liable
for accuracy-related penalties under section 6662(a).
Background
Some of the facts are stipulated and are so found. The stipulation of facts and
the attached exhibits are incorporated herein by this reference. Petitioners resided in
Tennessee when their petition was filed.
1
Unless otherwise indicated, section references are to the Internal Revenue
Code in effect for tax years at issue, and Rule references are to the Tax Court Rules
of Practice and Procedure.
2
Respondent concedes an error in the notice of deficiency. The correct
Federal income tax deficiencies are $2,865, $9,613, and $4,133 for 2005, 2006, and
2007, respectively; and the correct amounts of penalties under sec. 6662 are $573,
$1,922.60, and $826.60 for 2005, 2006, and 2007, respectively. Petitioners
concede the inclusion of $7,487 of cancellation of indebtedness income and the
disallowance of itemized deductions of $12,316 for 2006. Adjustments to itemized
deductions for 2005 and 2007 are computational.
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During 2005, 2006, and 2007, the tax years at issue, Mr. Chambers worked
as a full-time civilian employee for the Department of the Navy (Navy). The Navy
paid Mr. Chambers for 2,080 hours of work, which included 208 hours of annual
leave, 104 hours of sick leave, and 88 hours of holiday leave. After reducing his
2,080 hours for annual, sick, and holiday leave, Mr. Chambers worked 1,680 hours
each year at issue.
Mrs. Chambers also worked as a full-time civilian employee for the Navy
during each year at issue. In addition to her full-time employment she worked part
time for Dillard’s, Inc., in 2005 and part time for Macy’s, Inc., in 2005 and 2006.
Petitioners’ Properties
During the years at issue petitioners owned a single-family rental property in
San Diego, California. Petitioners were also responsible for the rental real estate
activities of CMB Capital Investments, LLC (CMB Capital), a Tennessee limited
liability company (LLC) in which Mr. Chambers owned a 33% interest. CMB
Capital had three equal members.
CMB Capital was organized as a member-managed LLC with the purpose of
investing in real estate. CMB Capital owned four properties in Tennessee during
2005 and eight during 2006 and 2007. Only three of the properties were rented in
2005, and four were rented in 2006 and 2007.
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On their 2005, 2006, and 2007 Federal income tax returns, petitioners
reported rental real estate losses of $8,901, $25,980, and $33,410, respectively.
The losses combined petitioners’ rental real estate losses from the San Diego
property, which were $11,092, $15,405, and $15,907 for 2005, 2006, and 2007,
respectively, with Mr. Chambers’ share of CMB Capital passive income and losses.
Petitioners reported adjusted gross income (AGI) of $153,955, $150,428, and
$146,993 for 2005, 2006, and 2007, respectively.
In a recomputation of petitioners’ Federal income tax deficiencies, see supra
note 2, respondent disallowed $8,901, $15,405, and $14,404 of petitioners’ rental
real estate losses for 2005, 2006, and 2007, respectively. Respondent recalculated
petitioners’ AGI as follows: $164,856 for 2005, $175,320 for 2006, and $164,900
for 2007.
Petitioners’ Real Estate Logs
Petitioners submitted logs detailing the amount of time they purportedly
spent on rental real estate activities. The logs, which petitioners prepared in
connection with the Internal Revenue Service’s audit of their returns, are based
upon a review of rent receipt books, bank statements, spreadsheets for repairs,
maintenance logs, and other activities associated with renting, such as collecting
rent. Collecting rent, according to petitioners, involved the following: receiving
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notification that the rent was available, traveling to pick up the rent or making
arrangements with the renter to send a payment, receiving the payment, depositing
the payment, and issuing a receipt.
The logs record 832 hours of real estate activities for 2005, 848 hours for
2006, and 936 hours for 2007. The hours combine time spent on the San Diego and
CMB Capital properties by petitioners, subcontractors, and another member of
CMB Capital, who was a painter and carpenter. Included in the log entries are: (1)
three to four hours per month, per property, for collecting rent; (2) 385 hours in
2005 and 185 hours in 2006 of viewing foreclosure properties; and (3) 220 hours in
2007 of time spent at Lowe’s and Home Depot. The logs do not record petitioners’
prep time and phone calls related to their real estate activities.
Notice of Deficiency
On December 15, 2009, respondent issued a notice of deficiency to
petitioners for 2005, 2006, and 2007. Petitioners timely filed a petition contesting
the deficiencies, and a trial was held in Memphis, Tennessee, on June 6, 2011.
Despite receiving an extension of time to file their answering brief until October 19,
2011, petitioners have failed to do so.
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Discussion
I. Burden of Proof
Generally, the Commissioner’s determination of a deficiency is presumed
correct, and the taxpayer bears the burden of proving it incorrect. See Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). Moreover, deductions are a matter
of legislative grace, and the taxpayer bears the burden of proving his entitlement to
any deductions claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Under
section 7491(a), the burden of proof may shift to the Commissioner if the taxpayer
produces credible evidence with respect to any relevant factual issue and meets
other requirements. Petitioners have not argued that section 7491(a) applies, and
therefore the burden of proof remains on them.
II. Passive Activity Losses
Section 469 generally disallows passive activity losses for any taxable year.
A passive activity loss is defined as the excess of the aggregate losses from all
passive activities for a taxable year over the aggregate income from all passive
activities for that year. Sec. 469(d)(1). Passive activities include any trade or
business in which the taxpayer does not materially participate, sec. 469(c)(1), or,
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to the extent provided in regulations, any activity with respect to which expenses are
allowable as a deduction under section 212, sec. 469(c)(6)(B).
Rental activity is generally treated as per se passive regardless of whether the
taxpayer materially participates. Sec. 469(c)(2), (4). There are, however, two
exceptions: (1) for real estate professionals under section 469(c)(7), and (2) for
passive activity losses up to $25,000 under section 469(i).
A. Real Estate Professional
Under section 469(c)(7) rental activities of taxpayers in real property trades
or businesses are not per se passive, but rather are treated as trades or businesses
subject only to the material participation requirements of section 469(c)(1). A
taxpayer qualifies as a real estate professional if: (1) 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 (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). A taxpayer must satisfy both
requirements of section 469(c)(7)(B) to qualify as a real estate professional. For
taxpayers filing a joint return, either spouse may separately satisfy the real estate
professional requirements. Id.
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The first part of the definition of a real estate professional under section
469(c)(7)(B) requires that Mr. Chambers have performed more than one-half of his
personal services in trades or businesses during the years at issue in real property
trades or businesses in which he materially participated. See Moss v.
Commissioner, 135 T.C. 365 (2010). “Personal services” means any work
performed by an individual in connection with a trade or business, sec. 1.469-
9(b)(4), Income Tax Regs., and a trade or business includes being an employee, see
Fowler v. Commissioner, T.C. Memo. 2002-223.
Mr. Chambers was an employee of the Navy and worked at least 1,680 hours
during each year at issue. In addition to working as an employee, Mr. Chambers
claims that he managed the San Diego and CMB Capital rental properties for 832
hours in 2005, 848 hours in 2006, and 936 hours in 2007. Mr. Chambers’ total
personal services working hours for the years at issue are: 2,512 hours in 2005,
2,528 hours in 2006, and 2,616 hours in 2007. As a result, to meet the first part of
the real estate professional definition, petitioners must show that Mr. Chambers
spent more than one-half of 2,512 hours in 2005, 2,528 hours in 2006, and 2,616
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hours in 2007 working in real property trades or businesses in which he materially
participated.3
Before the Court may address the number of hours Mr. Chambers spent on
real property trades or businesses, the Court must determine whether he may include
his time spent on real estate activities for CMB Capital. Section 469(h)(2) provides
that “Except as provided in regulations, no interest in a limited partnership as a
limited partner shall be treated as an interest with respect to which a taxpayer
materially participates.” Therefore, there is a presumption of passive activity for
taxpayers with interests in limited partnerships as limited partners. See Garnett v.
Commissioner, 132 T.C. 368, 372 (2009). General partners, however, are excepted.
See sec. 1.469-5T(e)(3)(ii), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb.
25, 1988).
3
Petitioners acknowledge that Mr. Chambers worked approximately 1,680
hours for the Navy each year at issue. Nonetheless petitioners maintain that Mr.
Chambers satisfied the first part of the definition of a real estate professional
because he spent 832 hours in 2005, 848 hours in 2006, and 936 hours in 2007 on
real property trades or businesses. Because one-half of 1,680 is 840, the Court
suspects that petitioners have misinterpreted sec. 469(c)(7)(B)(i) to require Mr.
Chambers to spend more than one-half of his hours with the Navy on real property
trades or businesses. As discussed above, the real estate professional definition
combines a taxpayer’s personal services for all trades or businesses, e.g., his hours
spent as an employee and on rental properties, and requires more than one-half of
the combined hours to be spent on real property trades or businesses.
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In Garnett v. Commissioner, 132 T.C. at 372, the Court held that an interest
in an Iowa LLC was not an “interest in a limited partnership as a limited partner”
within the meaning of section 469(h)(2) or the regulations thereunder. The Court
held that a member of an Iowa LLC, unlike a limited partner, was not prohibited by
State law from participating in the partnership’s business and, consequently, more
closely resembled a general partner. Id. at 380. Accordingly, the special rules of
section 469(h)(2) did not apply to an interest in an Iowa LLC. Id. at 381.
Mr. Chambers was a member of CMB Capital, an LLC that was organized in
Tennessee. A member, under Tennessee law, may participate in the management of
the LLC. Tenn. Code Ann. sec. 48-205-101(5) (2002). Moreover, according to its
articles of organization, CMB Capital was member managed. Mr. Chambers was
therefore not only allowed to participate in the management of CMB Capital by
Tennessee law, but also, as a member manager, was required to do so by the articles
of organization.
Furthermore, Mr. Chambers provided credible testimony that he managed the
day-to-day operations of CMB Capital, which involved, among other things,
overseeing CMB Capital’s rental properties in Tennessee. Mr. Chambers therefore
functioned more like a general partner of a limited partnership and, as a result, he
comes within the general partner exception of section 1.469-5T(e)(3)(ii), Temporary
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Income Tax Regs., supra. The Court concludes that the special rules of section
469(h)(2) do not apply to Mr. Chambers. Consequently, his time spent on real
estate activities for CMB Capital is included in his calculation of hours performed in
real property trades or businesses for purposes of section 469(c)(7)(B).
A taxpayer may use any reasonable means to establish his hours of
participation. Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg.
5727 (Feb. 25, 1988).4 Reasonable means “may include but are not limited to the
identification of services performed over a period of time and the approximate
number of hours spent performing such services during such period, based on
appointment books, calendars, or narrative summaries.” Id. Although
contemporaneous daily time reports, logs, or similar documents are not required, see
id., the Court has held that the regulations “concerning the records to be maintained
by taxpayers * * * by no means allow a postevent ‘ballpark guesstimate’”, Carlstedt
v. Commissioner, T.C. Memo. 1997-331 (citing Speer v. Commissioner, T.C.
Memo. 1996-323).
4
Material participation pursuant to sec. 469(c)(7) has the same meaning as
under sec. 1.469-5T, Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25,
1988). Sec. 1.469-9(b)(5), Income Tax Regs.
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Petitioners stipulated that Mr. Chambers spent at least 1,680 hours working
for the Navy during each year at issue. Thus, in order to satisfy the requirements
of section 469(c)(7)(B)(i) petitioners must show that Mr. Chambers devoted more
than 1,680 hours to his rental real estate businesses.5 See Anyika v.
Commissioner, T.C. Memo. 2011-69. As discussed above, because CMB Capital
is a member-managed LLC in which Mr. Chambers performed managerial tasks,
his time spent on rental real estate activities for CMB Capital is included in his
calculation of hours performed in real property trades or businesses.6 See, e.g.,
Garnett v. Commissioner, 132 T.C. at 376-381.
At trial petitioners submitted logs purportedly showing that, jointly, they
spent 832 hours performing rental real estate activities during 2005, 848 hours
during 2006, and 936 hours during 2007. Some of the hours recorded do not
qualify for purposes of section 469(c)(7)(B)(i) because the hours, in part, are
5
See supra note 3.
6
Time allocation for taxpayers with interests in more than one rental property
is determined separately with respect to each property, unless the taxpayer makes an
election to treat all interests in rental real estate as a single rental real estate
activity. Sec. 469(c)(7)(A); sec. 1.469-9(e)(1), Income Tax Regs. The record does
not address whether petitioners made an election to treat the San Diego and CMB
Capital properties as a single activity. Assuming petitioners made this election,
however, the time Mr. Chambers spent on all rental real estate activities is less than
the 1,680-hour threshold.
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attributed to Mrs. Chambers.7 See sec. 469(c)(7)(B). Nonetheless, even if all of the
hours qualified, the time recorded for real estate activities is less than the 1,680
hours Mr. Chambers spent working for the Navy. To wit, Mr. Chambers spent
more than one-half of his personal services on trades or businesses, i.e., as an
employee of the Navy, that are not related to his rental real estate businesses.
Accordingly, Mr. Chambers failed to meet the hours required under section
469(c)(7)(B)(i), and the Court need not address the 750-hour requirement in section
469(c)(7)(B)(ii). Mr. Chambers was therefore not a real estate professional under
section 469(c) during the years at issue and, unless relief provided under section
469(i) applies, the real estate losses sustained during those years are passive activity
losses disallowed by section 469(a).
B. Offset for Rental Real Estate Activities
The second exception to the general rule that rental real estate activities are
per se passive is found in section 469(i). Section 469(i) provides that a taxpayer
who actively participates in rental real estate activities may deduct up to $25,000
per year for related passive activity losses. Sec. 469(i)(1) and (2). Taxpayers may
satisfy the active participation requirement by participating in management
7
Mrs. Chambers’ ownership interest was limited to the San Diego property.
There was no evidence suggesting that she was an employee or independent
contractor of CMB Capital.
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decisions, such as approving new tenants, deciding rental terms, and arranging
services and repairs. Madler v. Commissioner, T.C. Memo. 1998-112. The
$25,000 amount begins to phase out when the taxpayer’s AGI, determined without
regard to any passive activity loss, exceeds $100,000, and is phased out entirely
when the taxpayer’s AGI reaches $150,000. Sec. 469(i)(3).
On each of their 2005, 2006, and 2007 Federal income tax returns, petitioners
claimed that they actively participated in rental real estate activities and deducted
$25,000 of passive activity losses. Respondent does not dispute that petitioners
actively participated in rental real estate activities, and the record does not suggest
otherwise. Instead, respondent asserts that petitioners’ AGI for each year at issue
exceeds $150,000, thereby making them ineligible for the $25,000 deduction or any
part thereof.
For 2005, 2006, and 2007 petitioners reported AGI of $153,955, $150,428,
and $146,993, respectively. After concessions by the parties, see supra note 2,
petitioners’ AGI is increased to include cancellation of indebtedness income and
disallowed itemized deductions. According to respondent’s concession on
petitioners’ deficiencies, their AGI for purposes of the section 469(i) phase out is
$164,856, $175,320, and $164,900, for 2005, 2006, and 2007, respectively.
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Because their AGI for each year at issue exceeds $150,000, petitioners are not
entitled to deduct $25,000 per year of passive activity losses under section 469(i).
III. Accuracy-Related Penalties
Respondent determined that petitioners are liable for section 6662 accuracy-
related penalties for the years at issue. After concessions, see supra note 2,
respondent determined accuracy-related penalties of $573, $1,922.60, and $826.60
for 2005, 2006, and 2007, respectively.
Section 6662(a) and (b)(1) and (2) provides an accuracy-related penalty equal
to 20% of the underpayment attributable to any substantial understatement of
income tax or to negligence or disregard of rules or regulations. However, no
penalty will be imposed under section 6662(a) if the taxpayer establishes that he
acted with reasonable cause and in good faith. Sec. 6664(c)(1). Circumstances that
indicate reasonable cause and good faith include reliance on the advice of a tax
professional or an honest misunderstanding of the law that is reasonable in the light
of all the facts and circumstances. Sec. 1.6664-4(b), Income Tax Regs.; see Higbee
v. Commissioner, 116 T.C. 438, 449 (2001). The taxpayer has the burden of
proving that he acted with reasonable cause and in good faith. Rule 142(a); Reilly
v. Commissioner, 53 T.C. 8, 14 (1970).
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At trial Mr. Chambers provided credible testimony that he devoted a
significant amount of time to the rental activities of the San Diego and CMB Capital
properties. His rental real estate activities included, among other things, renting
properties, collecting rents, purchasing materials, and scheduling repairs for the San
Diego property and the CMB Capital properties, which comprised three rented
properties in 2005 and four in 2006 and 2007. What is more, during the years at
issue, Mr. Chambers was primarily responsible for making all management
decisions, including market research and negotiation of real estate purchases, on
CMB Capital’s behalf.
Most of Mr. Chambers’ rental real estate activities were corroborated by
documentary evidence and recorded in petitioners’ real estate logs. Petitioners,
however, failed to account for real estate activities that could not be documented,
such as prep time and phone calls, and as a result did not meet their burden of proof.
Moreover, as discussed above, the Court surmises that petitioners misinterpreted the
real estate professional requirements of section 469(c)(7) to require Mr. Chambers
to devote more than one-half of his 1,680 personal service hours as an employee of
the Navy to real property trades or businesses. See supra note 3.
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The Court is convinced that petitioners had reasonable cause to believe that
Mr. Chambers qualified as a real estate professional and materially participated in
their rental real estate activities. The Court therefore declines to sustain the
accuracy-related penalties with respect to those portions of petitioners’
underpayments attributable to their rental real estate loss deductions claimed for the
years at issue.
The Court has considered the parties’ arguments and, to the extent not
addressed herein, concludes that they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.