T.C. Summary Opinion 2014-54
UNITED STATES TAX COURT
OSCAR M. ALFARO AND BLANCA M. ALFARO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20004-12S. Filed June 16, 2014.
Oscar M. Alfaro and Blanca M. Alfaro, pro sese.
David J. Warner, Emma S. Warner, and Willis B. Douglass, for respondent.
SUMMARY OPINION
GALE, Judge: This case was heard pursuant to the provisions of section
7463 of the Internal Revenue Code in effect when the petition was filed.1 Pursuant
1
Unless otherwise noted, all section references are to the Internal Revenue
Code of 1986, as in effect for the year at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
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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.
Respondent determined a deficiency in petitioners’ 2010 Federal income tax
of $11,816 and an accuracy-related penalty under section 6662(a) of $2,363.2 The
issues for decision are: (1) whether section 469 bars petitioners from deducting a
loss from their rental real estate activity for 2010; and (2) whether petitioners are
liable for an accuracy-related penalty.
Background
Some of the facts have been stipulated and are so found. The stipulation of
facts and the accompanying exhibits are incorporated herein by this reference. At
the time the petition was filed, petitioners resided in California.
Throughout 2010 petitioners worked full time as employees--petitioner
Blanca M. Alfaro at a hospital and petitioner Oscar M. Alfaro at a factory. For the
year, Mr. Alfaro worked at the factory a total of 1,680 hours, averaging 35 hours
per week, for a total of 48 weeks, with 2 weeks of vacation, 1 week of sick leave,
and 1 week during which the factory was closed.
Petitioners owned two rental properties during 2010. They personally
performed services relating to the management of the rental properties, such as rent
2
All dollar amounts are rounded to the nearest whole dollar.
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collection, maintenance, and repairs. Between them, Mr. Alfaro spent more time
performing these services. Petitioners kept a calendar book with handwritten notes
of the time they spent performing services with respect to their rental properties
during 2010. The calendar book shows 256 hours of these services performed by
both petitioners during 2010, as follows:
Month Total Hours
January 4
February 29
March 114
April 29
May 16
June 18
July 10
August 4
September 26
October 2
November 2
December 2
Total 256
The expenses petitioners incurred with respect to the rental properties
(including depreciation), which respondent concedes are fully substantiated,
exceeded the income from the properties by $44,266. Petitioners claimed a loss in
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that amount on a Schedule E, Supplemental Income and Loss, attached to their
Federal income tax return for 2010. The return reported adjusted gross income of
$127,159. The return was prepared by a certified public accountant with whom
petitioners consulted for that purpose. Among the materials petitioners provided to
their accountant were the records of the rental property expenses they incurred and
the calendar book in which they had recorded the hours spent performing services
with respect to the rental properties.
Respondent issued a notice of deficiency to petitioners in which he
determined that the rental real estate loss petitioners claimed on Schedule E was
not allowable, that certain computational adjustments to petitioners’ miscellaneous
itemized deductions were necessary, and that petitioners were liable for an
accuracy-related penalty under section 6662. Petitioners timely petitioned for
redetermination.
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Discussion
Rental Real Estate Losses
Deductions are a matter of legislative grace, and the burden of showing
entitlement to a claimed deduction is on the taxpayer.3 Rule 142(a); INDOPCO,
Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
Taxpayers may claim deductions for certain business and investment
expenses under sections 162 and 212. However, section 469, applicable to
individuals and certain other taxpayers, disallows any “passive activity loss” for
the taxable year. A “passive activity loss” is the amount by which the aggregate
losses from all passive activities for the taxable year exceed the aggregate income
from all passive activities for such year. Sec. 469(d)(1). A “passive activity” is
any activity which involves the conduct of any trade or business in which the
taxpayer does not materially participate.4 Sec. 469(c)(1).
3
Petitioners have not claimed or shown entitlement to any shift in the burden
of proof pursuant to sec. 7491(a).
4
In general, a taxpayer “materially participates” in a trade or business if the
taxpayer is involved in the operations of the trade or business on a regular,
continuous, and substantial basis. Sec. 469(h)(1). Congress authorized the
Secretary to prescribe regulations that specify what constitutes material
participation, see sec. 469(l)(1), and the Secretary promulgated seven regulatory
tests in sec. 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726
(Feb. 25, 1988). A taxpayer who satisfies any one of the seven tests meets the
material participation requirement.
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Rental real estate activities are generally treated as per se passive activities
regardless of whether the taxpayer materially participates. Sec. 469(c)(2), (4).
However, an exception is made for certain taxpayers who materially participate in
real property trades or businesses--so-called real estate professionals. The rental
real estate activities of these taxpayers are not automatically deemed passive
activities but instead are treated as trades or businesses subject to the material
participation requirements of section 469(c)(1). Sec. 1.469-9(e)(1), Income Tax
Regs. A taxpayer qualifies for this exception if:
(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). In the case of a joint return, one spouse must separately satisfy
both requirements. Id.
For purposes of the foregoing exception, “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., including in the capacity of an employee who
satisfies the ownership requirement of section 469(c)(7)(D)(ii), see Fowler v.
Commissioner, T.C. Memo. 2002-223, 2002 WL 31005826, at *5. A “real
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property trade or business” means any real property development, redevelopment,
construction, reconstruction, acquisition, conversion, rental, operation,
management, leasing, or brokerage trade or business. Sec. 469(c)(7)(C).
Taxpayers may establish the amount of personal services that they
performed in a real property trade or business by any reasonable means. Sec.
1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).
While the regulations do not prescribe records that a taxpayer must maintain, they
do not allow a postevent “ballpark guesstimate”. Moss v. Commissioner, 135 T.C.
365, 369 (2010).
The parties do not dispute that petitioners incurred the rental real estate loss
that they claimed on their return. They dispute whether either Mr. or Mrs. Alfaro
qualifies for the exception under section 469(c)(7)(B) for taxpayers engaged in a
real property business. Petitioners argue that Mr. Alfaro, who spent more time
performing services with respect to their rental properties than Mrs. Alfaro, so
qualifies. As reflected in our findings, Mr. Alfaro worked 1,680 hours at the
factory where he was employed during 2010.5 Therefore, to establish that he
qualifies for the exception provided in section 469(c)(7), petitioners must show
that Mr. Alfaro performed more than 1,680 hours of services (that is, more time
5
Petitioners have not contended that Mr. Alfaro’s factory work was
performed in connection with a real property trade or business.
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than he worked at the factory) in real property trades or businesses in which he
materially participated during 2010.
Petitioners have not established this. They rely on a calendar book with
handwritten notes of the time they spent performing services with respect to the
rental properties, but that time totals only 256 hours (for both of them). Petitioners
testified that Mr. Alfaro spent more time working at the properties than was
recorded in the calendar book, but their testimony is simply too vague to support a
finding that he spent approximately 1,400 hours more--as would be required to
show that his time working at the properties exceeded his time working at his
factory job. Petitioners’ testimony emphasized that Mr. Alfaro took two weeks off
from work in March 2010 to perform extensive repairs at one of the properties that
tenants had damaged, but those hours appear fully accounted for in the calendar
book.6 As to any hours beyond that, petitioners testified that Mr. Alfaro typically
left his factory job at 2:30 or 3 p.m. weekdays and went directly to one of the
properties and spent weekends there as well. In order for Mr. Alfaro to have
approximated 1,400 hours of rental-property-related work following this schedule
in 2010, it would have been necessary for him to work at the rental properties 3
6
As noted in our findings, petitioners’ calendar book recorded 114 hours of
rental-property-related work for March 2010, an amount that is approximately four
times greater than the hours recorded for any other month.
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hours every weekday after work and 14 hours every weekend.7 On this record, we
are not persuaded that he did so. Because petitioners’ evidence falls considerably
short of demonstrating that Mr. Alfaro spent more than 1,680 hours during 2010
performing services with respect to the rental properties, he does not qualify for the
section 469(c)(7)(B) exception and petitioners’ rental real estate activities are
deemed to be passive activities under section 469(c)(2).
In addition to the exception from the passive loss limitation for real estate
professionals, there is an exception under which up to $25,000 in annual losses
from rental real estate activities may be deducted (without regarded to the passive
loss limitation) by individuals who “actively participated”8 in the rental activity.
See sec. 469(i)(1) and (2). This exception is fully phased out, however, when the
taxpayer’s adjusted gross income equals or exceeds $150,000, including taxpayers
7
Our estimate treats Mr. Alfaro’s two vacation weeks as accounted for and
his week of sick leave as a week where he did not perform services at the rental
properties. The estimate likewise assumes that Mr. Alfaro performed no
significant rental-property-related work during the one week in 2010 during which
the factory at which he worked was closed. We find that, had Mr. Alfaro spent that
week working at the rental properties as he did during his two weeks of vacation,
either he or Mrs. Alfaro would have recalled that fact and testified to it. They did
not.
8
The “active participation” standard is met as long as the taxpayer
participated in a significant and bona fide sense in making management decisions
or arranging for others to provide services such as repairs. See Madler v.
Commissioner, T.C. Memo. 1998-112.
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filing a joint return. See sec. 469(i)(3)(A). For this purpose, adjusted gross
income is determined without regard to any passive activity loss or loss allowable
under section 469(c)(7). Sec. 469(i)(3)(F)(iv). Disregarding petitioners’ passive
activity loss of $44,266 for 2010, their adjusted gross income is $171,425.
Therefore, they are not entitled to deduct any passive activity losses under section
469(i).
We therefore sustain respondent’s determination disallowing the $44,266
loss arising from petitioners’ rental real estate activities in 2010.9
Accuracy-Related Penalty
Section 6662(a) and (b)(2) imposes a penalty equal to 20% of any
underpayment of tax required to be shown on a return that is attributable to a
substantial understatement of income tax. However, the section 6662(a) penalty is
not imposed on any portion of an underpayment if the taxpayer shows there was
reasonable cause for that portion of the underpayment and that he acted in good
faith with respect thereto. Sec. 6664(c)(1). The determination of whether a
taxpayer had reasonable cause and acted in good faith is made on a case-by-case
basis, taking into account all pertinent facts and circumstances. Sec. 1.6664-
9
We note that petitioners are entitled to carry forward the disallowed loss
and may be able to deduct it in subsequent tax years. See sec. 469(b), (g); Lowe v.
Commissioner, T.C. Memo. 2008-298, 2008 WL 5396602, at *3.
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4(b)(1), Income Tax Regs. Generally, the most important factor is the taxpayer’s
effort to assess his proper tax liability. Id. A taxpayer can show reasonable cause
and good faith by showing that the taxpayer reasonably relied in good faith on
professional advice regarding the taxpayer’s return. Id. An honest
misunderstanding of the law may be reasonable in view of the taxpayer’s
knowledge, education, and experience. Id. These factors, as well as the taxpayer’s
sophistication, are also considered in assessing the reasonableness of the taxpayer’s
reliance on professional advice. Sec. 1.6664-4(c)(1), Income Tax Regs.
On the facts and circumstances of this case, we conclude that petitioners had
reasonable cause and acted in good faith with respect to the underpayment
attributable to the disallowance of their rental real estate loss. Respondent
conceded that petitioners fully substantiated all the expenses reported with respect
to their rental properties. Petitioners hired a certified public accountant to prepare
their return. Mrs. Alfaro was petitioners’ point of contact with the accountant, and
she testified that, on the basis of her discussions with the accountant, she believed
that petitioners could claim deductions for substantiated expenses relating to their
rental properties so long as they kept a log of the hours they performed services
with respect to the properties. While it is unclear whether the accountant gave
poor instructions or petitioners misunderstood those instructions, the fact remains
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that the accountant prepared the return deducting the rental real estate loss. We are
satisfied that, in keeping a log and fully substantiating their expenses, petitioners
made a reasonable effort to comply with the law, and their reliance on the
accountant to take the correct position with respect to the passive loss limitations
was reasonable in these particular circumstances. Petitioners therefore had
reasonable cause with respect to the underpayment on their return and are not
liable for any penalty under section 6662.
To reflect the foregoing,
Decision will be entered for
respondent as to the deficiency in tax and for
petitioners as to the accuracy-related
penalty.