123 T.C. No. 16

UNITED STATES TAX COURT

TONY R. CARLOS AND JUDITH D. CARLOS, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5512-03. Filed September 20, 2004.

Ps owned and actively engaged in the conduct of

two S corporations, B and J. B rented real property BB

from Ps, and J rented real property JJ from Ps. Ps

grouped the two rentals together to make up a single

passive “activity” for purposes of sec. 469, I.R.C. B

paid its rent on BB according to its lease with Ps,

resulting in income to Ps. J did not pay its rent on

JJ under its lease with Ps, resulting in a loss to Ps. 

Ps netted the income and loss from the two rentals,

claiming nonpassive net rental income. R, however,

determined that the income and loss items could not be

netted, that the income from renting BB was nonpassive

and the loss from renting JJ was passive, and that Ps

could not offset the nonpassive BB income with the

passive JJ loss. 

Held: Sec. 1.469-2(f)(6), Income Tax Regs.,

recharacterizes rental income from the taxpayer’s

active business as nonpassive, thereby removing such
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1Although respondent initially determined sec. 6662(a)

accuracy-related penalties of $3,402.20 for 1999 and $3,276.80

for 2000, respondent concedes that penalties are inapplicable.

2All section references are to the Internal Revenue Code, as

amended, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

income from the calculation of passive loss for a sec.

469, I.R.C. activity, despite the proper grouping of

such income with an item of passive loss against which

such income would otherwise be offset.

Murray H. Falk, for petitioners.

Paul L. Dixon, for respondent.

OPINION

WELLS, Judge: Respondent determined deficiencies in

petitioners’ Federal income taxes for 1999 and 2000 as follows:1

Year Deficiency

1999 $17,011

2000 

114,443

1Although respondent initially determined corresponding

deficiencies of $17,011 and $16,384 for 1999 and 2000,

respectively, the parties have stipulated that the deficiency

determined by respondent for 2000 is $14,443.

The issue to be decided is whether losses from petitioners’

rental activity constitute passive activity losses pursuant to

section 469.2
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Background

The parties have submitted the instant case fully

stipulated, without trial, pursuant to Rule 122. The parties’

stipulations of fact are incorporated herein by reference and are

found as facts in the instant case.

Petitioners are husband and wife. At the time of filing

their petition, petitioners resided in Apple Valley, California. 

During the years in issue, petitioners owned two commercial

real estate properties in Apple Valley, California. One property

was located at 22040 Bear Valley Road (Bear Valley Road

property), and the other was located at 13685/13663 John Glenn

Road (John Glenn Road property). Collectively, the Bear Valley

Road property and the John Glenn Road property are referred to as

the rental properties. Petitioners also owned all of the stock

of two S corporations—-Bear Valley Fabricators & Steel Supply,

Inc. (steel company), and J&T’s Branding Company, Inc.

(restaurant). 

During 1999 and 2000, petitioners leased the Bear Valley

Road property to the steel company and leased the John Glenn Road

property to the restaurant. 

The steel company agreed to pay rent of $120,000 per year to

petitioners for the Bear Valley Road property. The steel company

paid the rent, which, after taxes, depreciation, and bank

charges, resulted in net rental income to petitioners for the
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Bear Valley Road property of $102,646 in 1999 and $102,045 for

2000.

The restaurant agreed to pay rent of $60,000 per year to

petitioners for the John Glenn Road property. The restaurant

failed to pay its designated rent in 1999 and 2000, which, after

mortgage interest, taxes, depreciation, and amortization incurred

by petitioners, resulted in a net loss to petitioners for the

John Glenn Road property of $41,706 in 1999 and $40,169 in 2000. 

Petitioners grouped the rental properties together to

constitute a single “activity”. On Schedules E, Supplemental

Income and Loss, of their 1999 and 2000 income tax returns,

petitioners netted the income from the Bear Valley Road property

and the loss from the John Glenn Road property. For 1999,

petitioners subtracted the $41,706 net loss on the John Glenn

road property from the $102,646 net income on the Bear Valley

Road property, resulting in net rental income of $60,940. 

Similarly, for 2000, petitioners subtracted the $40,169 net loss

on the John Glenn Road property from the $102,045 net income on

the Bear Valley Road property, resulting in net rental income of

$61,876. Petitioners reported the net rental income as not from

a passive activity and reported no passive activity loss.

Respondent disallowed petitioners’ net losses on the John

Glenn Road property under section 469(a) as passive activity

losses. 
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3SEC. 469. PASSIVE ACTIVITY LOSSES AND CREDITS LIMITED. 

(a) Disallowance.--

(1) In general.--If for any taxable year the 

taxpayer is described in paragraph (2), neither–-

(A) the passive activity loss, nor

(B) the passive activity credit, 

for the taxable year shall be allowed.

(2) Persons described.-- The following are 

described in this paragraph:

(A) any individual, estate, or trust, * * *. 

4 SEC. 469(c). Passive Activity Defined.--For purposes 

of this section–-

(1) In general.--The term “passive activity” means

any activity--

(A) which involves the conduct of any trade 

or business, and 

(B) in which the taxpayer does not materially 

participate.

(2) Passive activity includes any rental activity. 

* * * the term “passive activity” includes any 

rental activity.

Discussion

Section 469(a) disallows the passive activity loss of an

individual taxpayer.3 The Internal Revenue Code defines “passive

activity” as an activity involving the conduct of a trade or

business in which the taxpayer does not materially participate.4
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5Sec. 1.469-4(c)(2), Income Tax Regs., provides:

(2) Facts and circumstances test. Except as

otherwise provided in this section, whether activities

constitute an appropriate economic unit and, therefore,

may be treated as a single activity depends upon all

the relevant facts and circumstances. A taxpayer may

use any reasonable method of applying the relevant

facts and circumstances in grouping activities * * *. 

“Passive activity”, however, generally includes any rental

activity, regardless of material participation. Sec. 469(c)(2).

Section 469 does not define “activity”. See Schwalbach v.

Commissioner, 111 T.C. 215, 223 (1998). The Secretary, however,

has prescribed regulations pursuant to section 469(l) that

specify what constitutes an “activity”. Section 1.469-4(c),

Income Tax Regs., sets forth rules for grouping tax items

together to determine what constitutes a single “activity”. That

regulation provides: “One or more trade or business activities

or rental activities may be treated as a single activity if the

activities constitute an appropriate economic unit for the

measurement of gain or loss for purposes of section 469.” Sec.

1.469-4(c)(1), Income Tax Regs. Whether activities constitute an

“appropriate economic unit” depends on the facts and

circumstances.5 

Respondent concedes that petitioners’ grouping of the Bear

Valley Road property and the John Glenn Road property is an

appropriate economic unit. The parties, however, dispute the 
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method for computing passive activity loss within the “activity”

grouping. 

Section 469(d)(1) defines “passive activity loss” as “the

amount (if any) by which–-(A) the aggregate losses from all

passive activities for the taxable year, exceed (B) the aggregate

income from all passive activities for such year.” Passive

activity loss is computed by first netting items of income and

loss within each passive activity and then subtracting aggregate

income from all passive activities from aggregate losses. See

id.; sec. 1.469-2T, Temporary Income Tax Regs., 53 Fed. Reg. 5686

(Feb. 25, 1988). 

In carrying out the provisions of section 469, section

469(l)(2) authorizes the Secretary to promulgate regulations

“which provide that certain items of gross income will not be

taken into account in determining income or loss from any

activity (and the treatment of expenses allocable to such

income)”. While the general rule of section 469(c)(2)

characterizes all rental activity as passive, section 1.469-

2(f)(6), Income Tax Regs., requires net rental income received by

the taxpayer for use of an item of the taxpayer’s property in a

business in which the taxpayer materially participates to be

treated as income not from a passive activity (sometimes referred
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6To illustrate the self-rental rule, suppose taxpayer A owns

a property and all outstanding stock of B Corp. A materially

participates in the operations of B Corp., which generates $100

of income and has $50 of operating expenses in year 1. In year

1, A enters a lease agreement with B Corp. requiring B Corp. to

pay $50 of annual rent to A for A’s property. B Corp. uses the

property in year 1 as its headquarters. If B Corp. were to pay

its $50 net income to A in the form of salary, A would have $50

of income not from a passive activity. However, because the $50

of net income is paid to A in the form of rent, it is per se

passive income pursuant to sec. 469(c)(2). Sec. 1.469-2(f)(6),

Income Tax Regs., recharacterizes the $50 of net rental income as

not from a passive activity.

7As discussed below, sec. 1.469-2(f)(6), Income Tax Regs.,

is authorized by sec. 469(l)(2).

to as the self-rental rule or the recharacterization rule),6 and

provides:

(f)(6) Property rented to a nonpassive activity. 

An amount of the taxpayer’s gross rental activity

income for the taxable year from an item of property

equal to the net rental activity income for the year

from that item of property is treated as not from a

passive activity if the property–-

(i) Is rented for use in a trade or business

activity * * * in which the taxpayer materially

participates * * *.[7]

Petitioners concede that they “materially participated” in

the conduct of both the steel company and the restaurant during

1999 and 2000, and they do not contend that section 1.469-

2(f)(6), Income Tax Regs., is either invalid or inapplicable. 

Petitioners, however, contend that computation of passive

activity loss requires the netting of income and loss from all

items of rental property grouped within the section 469 passive

activity and that only after such a computation does section
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1.469-2(f)(6), Income Tax Regs., apply to recharacterize passive

income as nonpassive. Respondent contends that section 1.469-

2(f)(6), Income Tax Regs., requires the removal of self-rental

income from the passive activity loss computation and that, after

income from the Bear Valley Road property is properly removed

from the passive activity loss computation, petitioners are left

with no passive income to offset against the passive loss on the

John Glenn Road property. We conclude that section 469(d) and

the legislative regulations of section 1.469-2(f)(6), Income Tax

Regs., support respondent’s position.

Section 469(l)(2) explicitly authorizes the promulgation of

regulations to remove certain items of gross income from the

calculation of income or loss from any activity. Section 1.469-

2(f)(6), Income Tax Regs., is a legislative regulation and is

entitled to appropriate deference from this Court. See Chevron

U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837

(1984). In Chevron, the U.S. Supreme Court stated: “Such

legislative regulations are given controlling weight unless they

are arbitrary, capricious, or manifestly contrary to the

statute.” Id. at 844. We have previously held that section

1.469-2(f)(6), Income Tax Regs., is not arbitrary, capricious, or

manifestly contrary to section 469(l)(2). Krukowski v.

Commissioner, 114 T.C. 366 (2000), affd. 279 F.3d 547 (7th Cir.

2002); Shaw v. Commissioner, T.C. Memo. 2002-35; Sidell v.
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8Sec. 469(l)(2) authorizes the implementation of regulations

to remove “certain items of gross income” from the determination

of income from an “activity”. The designation of an “[item] of

gross income” to be removed from such a determination is narrower

than and distinct from the term “activity” income (from which the

item must be removed). Since sec. 1.469-2(f)(6), Income Tax

Regs., designates “net rental activity income for the year from 

* * * [an] item of property” as the item of gross income to be

removed pursuant to sec. 469(l)(2) from the determination of

income from the “activity”, net rental activity income from an

“item” of property is also narrower than and distinct from the

broader term “activity” income. 

9The fact that multiple rentals may be grouped together

pursuant to sec. 1.469-4(c), Income Tax Regs., to make up a

single “activity” further evidences the distinction between net

income from an “item” of property and net income from the entire

“activity”.

Commissioner, T.C. Memo. 1999-301, affd. 225 F.3d 103 (1st Cir.

2000). The Courts of Appeals for the First, Fifth, and Seventh

Circuits have also upheld the validity of section 1.469-2(f)(6),

Income Tax Regs. See Krukowski v. Commissioner, 279 F.3d 547

(7th Cir. 2002); Sidell v. Commissioner, 225 F.3d 103 (1st Cir.

2000); Fransen v. United States, 191 F.3d 599 (5th Cir. 1999).

Section 1.469-2(f)(6), Income Tax Regs., explicitly

recharacterizes net rental activity income from an “item of

property” rather than net income from the entire rental

“activity”. Both section 469 and the regulations thereunder

clearly distinguish between net income from an “item of property”

and net income from the entire “activity”,8 which might include

rental income from multiple items of property.9 Under the

authority of section 469(l)(2), the Secretary could have
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implemented regulations to remove items of gross income equal to

net income from the entire activity, but the Secretary instead

implemented regulations to recharacterize net income from a

specific item of self-rental property. The use of the term “item

of property” leads us to conclude that respondent’s

interpretation of the regulation is correct. Accordingly, in the

instant case, self-rental income from the Bear Valley Road

property is removed from the passive activity loss computation,

leaving no passive income to be offset by the passive loss on the

John Glenn Road property. 

Section 469(d)(1) defines passive activity loss as the

excess of losses from passive activities over income from passive

activities. Consequently, recharacterization of “self-rental

income” under section 1.469-2(f)(6), Income Tax Regs., as not

from a passive activity effectively removes the income from the

passive activity loss computation. Removal of a single item of

income from such computation does not affect the passive

characterization of items remaining within the activity. See

Shaw v. Commissioner, supra. “Under the self-rented property

rule, the net rental income from self-rented property is treated

as nonpassive income and the net rental losses are treated as

passive losses, even though the rental activities are passive

activities.” Id.
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10In Krukowski v. Commissioner, 279 F.3d 547, 554 (7th Cir.

2002), affg. 114 T.C. 366 (2000), the taxpayers raised the single

activity grouping argument on appeal, but the Court of Appeals

did not address the issue because the taxpayers had not elected

to treat the rental activities as a single activity on their

return. The taxpayers in Shaw v. Commissioner, T.C. Memo. 2002-

35, likewise, belatedly tried to raise the issue of single

activity grouping but were not allowed to do so. 

11In Fransen v. United States, 82 AFTR 2d 6621, 98-2 USTC

par. 50,776 (E.D. La. 1998), affd. 191 F.3d 599 (5th Cir. 1999),

the taxpayers similarly challenged application of sec. 1.469-

2(f)(6), Income Tax Regs., in an action for refund. The

taxpayers argued that sec. 1.469-2(f)(6), Income Tax Regs., is

invalid because it contradicts the statutory designation of

rental activity income as passive. The court awarded summary

judgment to the Commissioner, holding that sec. 1.469-2(f)(6),

Income Tax Regs., is consistent with the express congressional

purposes of sec. 469 and the authorizing language of sec.

(continued...)

Although we have not previously decided whether grouping

items of passive income and loss within a single section 469

activity precludes recharacterization under section 1.469-

2(f)(6), Income Tax Regs., of income that would otherwise offset

the passive loss,10 we have consistently upheld

recharacterization of passive income which would otherwise offset

passive loss without considering the effect of the activity

grouping. See, e.g., Krukowski v. Commissioner, 114 T.C. 355

(2000); Schwalbach v. Commissioner, 111 T.C. 215, 219-224 (1998);

Cal Interiors, Inc. v. Commissioner, T.C. Memo. 2004-99; Shaw v.

Commissioner, supra; Sidell v. Commissioner, T.C. Memo. 1999-301;

Connor v. Commissioner, T.C. Memo. 1999-185, affd. 218 F.3d 733

(7th Cir. 2000).11 In each of these cases, we validated
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11(...continued)

469(l)(3). 

application of section 1.469-2(f)(6), Income Tax Regs., to

recharacterize specific items of income, leaving remaining items

of passive loss with no offset. 

In the instant case, we conclude that activity grouping does

not preempt the application of section 1.469-2(f)(6), Income Tax

Regs. To hold otherwise would undermine the congressional

purpose for enacting section 469 and authorizing section 1.469-

2(f)(6), Income Tax Regs., to wit: the prevention of sheltering

of nonpassive income with passive losses. H. Conf. Rept. 99-841

(Vol. II), at II-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147. The

conference report accompanying section 469 describes this

legislative purpose:

Regulatory authority of Treasury in defining nonpassive income.--The conferees believe that

clarification is desirable regarding the regulatory

authority provided to the Treasury with regard to the

definition of income that is treated as portfolio

income or as otherwise not arising from a passive

activity. The conferees intend that this authority be

exercised to protect the underlying purpose of the

passive loss provision, i.e., preventing the sheltering

of positive income sources through the use of tax

losses derived from passive business activities. 

Examples where the exercise of such authority may

(if the Secretary so determines) be appropriate include

the following * * * (2) related party leases or subleases, with respect to property used in a business

activity, that have the effect of reducing active

business income and creating passive income * * *. [Id.]
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12Because sec. 1.469-2(f)(6), Income Tax Regs., would apply

to recharacterize self-rental income under petitioners’

interpretation only to the extent such income exceeds passive

losses within the activity grouping, only the excess would be

subject to recharacterization. An amount of passive income equal

to the amount of passive losses would retain its passive

character and, therefore, be sheltered by passive losses within

the grouping. 

13The result in this case might appear harsh, since, as

respondent’s brief recognizes, had the restaurant paid its rent

on the John Glenn Road property, petitioners could have properly

offset related expenses against that rental income. However, we

must base our decision on the facts of the instant case: the

(continued...)

The facts of the instant case appear to fall within the

description of activity that Congress intended to prevent.

Petitioners’ interpretation of section 1.469-2(f)(6), Income

Tax Regs., would effectively allow a taxpayer to subvert

Congress’s intent. Petitioners’ interpretation would allow a

taxpayer to convert nonpassive income into passive income against

which passive losses could be offset by manipulating the payment

of rent from a business controlled by the taxpayer on property

rented from the taxpayer to the controlled business.12 See Shaw

v. Commissioner, T.C. Memo. 2002-35. By converting nonpassive

income into passive income in this manner, such a taxpayer would

be able to shelter otherwise nonpassive income with passive

losses. Petitioners’ interpretation would allow petitioners to

shelter nonpassive income from the Bear Valley Road property with

passive loss from the John Glenn Road property, contrary to

congressional intent.13
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13(...continued)

restaurant did not pay its rent for the John Glenn Road property. 

Moreover, sec. 469(b) tempers the harshness of disallowing such

passive activity losses by allowing them to be carried forward.

14Petitioners contend that the issue raised by respondent as

to whether loss from the John Glenn Road rental should be

disallowed as a passive activity loss constitutes a “new matter”,

distinct from respondent’s original contention, set forth in the

statutory notice of deficiency, that net income from the Bear

Valley Road rental is recharacterized as nonpassive. We need not

address this issue, however, because we decide only a legal

issue, not a factual one, and the burden of proof therefore does

not affect our decision.

Accordingly, we hold that net rental income from the Bear

Valley Road property constitutes income not from a passive

activity. Net rental loss from the John Glenn Road property,

however, retains its characterization as loss from passive

activity. Consequently, the loss is properly disallowed under

section 469(a).14

To reflect the foregoing,

Decision with respect to the

deficiencies will be entered for

respondent; decision with respect

to the accuracy-related penalties

pursuant to section 6662(a) will be

entered for petitioners.