TAX COURT OPINION

Case: Paul E. Phillips
Docket Number: 19750-11S
Judge: Whalen
Opinion Type: bench
Filed: 11/05/2012
Pages: 17

UNITED STATES TAX COURT WASHINGTON, DC 20217 PAUL E. PHILLIPS, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. ) ) ) ) ) ) ) ) ) ORDER Docket No. 19750-11S Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit herewith to petitioner and to respondent a copy of the pages of the transcript of the proceedings in the above-case before the undersigned at Tampa, Florida, containing the oral findings of fact and opinion rendered on September 13, 2012. In accordance with the oral findings of fact and opinion, decision will be entered for respondent. (Signed) Laurence J. Whalen Judge Dated: Washington, D.C. November 5, 2012 SSVED NOV - 5 2012 Capital Reporting Company Paul E Phillips 09 13-2012 1 BENCH OPINION 2 Bench Opinion by Judge Laurence J. Whalen 3 Paul E. Phillips 4 September 10, 2012 (Trial Date) 5 6 7 8 9 10 11 I. THE COURT HAS DECIDED TO RENDER ORAL FINDINGS OF FACT AND OPINION IN THIS CASE, AND THE FOLLOWING REPRESENTS THE COURT'S ORAL FINDINGS OF FACT AND OPINION. II. This proceeding was heard as a Small Tax 12 Case pursuant to the provisions of section 7463 of 13 the Internal Revenue Code of 1986, as amended, and 14 Rules 170 through 179 of the Tax Court Rules of 15 Practice and Procedure. 16 17 III. This bench opinion is made pursuant to the 18 authority granted by section 7459 (b) of the Internal 19 Revenue Code of 1986, as amended, and Rule 152 of the 20 Tax Court Rules of Practice and Procedure. 21 Hereinafter all section references are to the 22 23 Internal Revenue Code, as amended and in effect for 2008 and 2009, the taxable years in issue, and all 24 rule references are to the Tax Court Rules of 25 Practice and Procedure. The decision to be entered (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E Phillips 09-13-2012 4 1 2 in this case is not reviewable by any other court, and this opinion should not be cited as authority. 3 Sec. 7463 (b) . 4 5 6 IV. Petitioner Paul E. Phillips appeared in these proceedings on his own behalf, and William R. 7 Brown, Esquire, appeared on behalf of Respondent. 8 9 V. Respondent determined a deficiency of 10 $11,010 in Petitioners' Federal income tax for 11 12 13 taxable year 2008, and a deficiency of $6,631 in his tax for taxable year 2009. Respondent also determined that Petitioner is liable for an accuracy-related 14 penalty under section 6662 (a) in the amount of $2,202 15 and $1,326.20 for 2008 and 2009, respectively. 16 The tax deficiencies in the Notice of 17 Deficiency are based upon the disallowance of certain 18 losses claimed on Schedule E, Supplemental Income and 19 Loss, from the operation and rental property located 20 21 22 23 24 on Watersong Way in Ft. Pierce, Florida (herein "Watersong House") . Petitioner claimed a loss of $39,646 on the property in 2008, and he claimed a loss of $81,604 on the property in 2009. In the Notice of Deficiency, Respondent 25 treated Petitioner as having actively participated (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 5 1 in the Watersong House activity, under section 2 469(i), during 2008 and 2009. Nevertheless, for 2008, 3 Respondent disallowed the entire loss because the 4 $25,000 exemption provided by section 469(i) was 5 phased-out pursuant to section 469(i) (3). For 2009, 6 Respondent reduced the loss reported by Petitioner to 7 8 9 10 11 $23,583 by application of the section 469(i) rules, and increased Petitioner's income by $58,021, as a result. VI. The issues for decision are (1) whether 12 Petitioner is entitled to deduct the losses from the 13 operation of the Watersong House that were claimed on 14 15 the Schedules E filed with his returns for 2008 and 2009; and (2) whether Petitioner is liable for the 16 accuracy-related penalty determined by Respondent 17 under section 6662 (a). 18 19 VII. Some of the facts have been stipulated by 20 the parties. The Stipulation of Facts and the First 21 Supplemental Stipulation of Facts filed by the 22 parties and the exhibits attached were taken into 23 evidence. Petitioner resided in Palm Coast, Florida, 24 at the time his petition was filed with the Court. 25 During the years in issue, Petitioner not (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 6 1 only owned Watersong House, mentioned above, but he 2 also owned Gulfside Motel, a garden apartment-motel 3 4 located in Sarasota, Florida, and two or three vacant lots in Flagler County. The deficiency determined by 5 Respondent only involves Watersong House, so we shall 6 7 8 9 10 11 12 devote our attention to that property. Watersong House started as an ocean-front lot in a subdivision that Petitioner purchased for $600,000 in 2005. He negotiated an agreement with the builder to construct a four-story, 3 bedroom, 3.5 bath single family home on the lot which the builder would lease 13 back for use as a model home. The agreement with the 14 builder is not included in the record of this case. 15 From time to time, Petitioner visited the 16 property and discussed the house with architects who 17 had been retained by the builder, and an interior 18 designer. He selected paint color, cabinets for the 19 house, tiles, and carpet. 20 21 22 The house was completed in November of 2008. Petitioner's cost for the house and lot amounted to approximately $1.5 or $1.6 million. 23 During 2008, builder paid $39,000 in rent to 24 Petitioner and during 2009, the building paid $30,000 25 to Petitioner before "reneging" on his lease-back (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 7 1 2 3 4 5 6 7 arrangement with Petitioner. After the house was completed in late 2008, Petitioner visited the house and performed various repairs and maintenance, such as changing corroded locks and other hardware, and repairing broken tiles. Ultimately, Petitioner sold the property in August 2012 for $600,000. Shortly before trial of this case. 8 Petitioner sent a letter to Respondent's counsel 9 which stated that he had spent 30 hours working on 10 11 12 13 14 15 the Watersong House during 2008 and 84 hours during 2009. At trial, Petitioner testified that he had revised those numbers to 105 hours and 134 hours, respectively. VIII. Our legal analysis in this case is 16 necessarily guided by several fundamental principles 17 of tax litigation. 18 First, as a general rule, the 19 Commissioner's determinations are presumed correct, 20 21 and the taxpayer bears the burden of proving that those determinations are erroneous. Rule 142(a). 22 This principle was firmly established by the United 23 States Supreme Court as early as 1933 and has been 24 reaffirmed more recently by the Court. See INDOPCO 25 Inc. v. Commissioner, 503 U. S. 79, 84 (1992) . (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 8 1 Parenthetically, we note that section 7491(a), which 2 shifts the burden of proof to the Commissioner in 3 certain cases, does not apply in this case because 4 Petitioner has not raised the issue nor has he shown 5 6 7 8 9 that this case meets the limitations imposed by section 7491(a) (2). Indeed, the principal issue in this case involves Petitioner's failure to substantiate the rental loss claimed on Schedule E. See sec. 7491(a) (2) (A) . 10 Second, deductions are a matter of 11 legislative grace, and the taxpayer bears the burden 12 of proving that he or she is entitled to any 13 deduction claimed. Rule 142(a); Deputy v. duPont, 14 308 U.S. 488, 493 (1940); New Colonial Ice Co. v. 15 Helvering, 292 U.S. 435, 440 (1934); Welch v. 16 Helvering, supra. This includes the burden of 17 substantiation. Hradesky v. Commissioner, 65 T.C. 18 87, 90 (1975), affd. per curiam 540 F.2d 821 (5th 19 Cir . 1976) . 20 Third, the Court is not bound to accept the 21 unverified and undocumented testimony of a taxpayer. 22 Hradesky v. Commissioner, supra; Tokarski v. 23 Commissioner, 87 T.C. 74, 77 (1986). 24 Fourth, a party's failure to introduce 25 documentary evidence that is within his possession or (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 9 1 control and that he implies would be favorable to 2 3 him, gives rise to the presumption that, if produced, such evidence would be unfavorable. Recklitis v. 4 Commissioner, 91 T.C. 874, 890 (1988); Pollack v. 5 Commis sioner, 47 T . C. 92, 10 8 (1966) , af fd . 392 F. 2d 6 409 (5th Cir. 1968); Wichita Terminal Elevator Co. V. 7 Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 8 9 F.2d 513 (10th Cir. 1947). Finally, we observe that section 6001 and 10 the regulations promulgated thereunder require 11 taxpayers to maintain records sufficient to permit 12 verification of income and expenses. 13 14 IX. The resolution of this case is controlled 15 by the application of the rules, set fourth in 16 section 469, governing the disallowance of passive 17 activity losses. Generally, those rules operate to 18 disallow the deduction of passive activity losses. 19 See section 469(a) (1) (A). A passive activity loss is 20 defined as the excess of the aggregate losses from 21 all passive activities for a particular year over the 22 23 24 25 aggregate income from all passive activities for the year. Sec. (469(d) (1). Passive activities include any trade or business in which the taxpayer does not "materially participate". Sec. 469(c) (1) . (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 10 1 Section 469(c) (2) provides a per se rule 2 which provides, "the term 'passive activity' includes 3 4 any rental activity". Under this provision, any rental activity, including a rental real estate 5 activity, such as Petitioner's Watersong House, is 6 defined as a "passive activity" and subject to the 7 8 9 10 11 12 loss disallowance rules of section 469(a) (1). There are two exceptions to the application of the per se rule in the case of a rental real estate activity. The first exception is found in section 469(c) (7) which applies to the rental activities of taxpayers engaged in real property trades or 13 businesses, so-called real estate professionals. 14 Under that exception, the losses from rental real 15 estate activities are not treated as per se passive 16 activities, but rather as trade or business 17 activities, subject to the material participation 18 requirements of section 469(c) (1). Sec. 469(c) (7); 19 see also sec. 1.469-9(e) (1), Income Tax Regs. A 20 taxpayer qualifies as a real estate professional, 21 under section 469 ( c) (B) , if : (i) more than one-half of 22 the personal services performed in trades or 23 businesses by the taxpayer during the taxable year 24 are performed in real property trades or businesses 25 in which the taxpayer materially participates, and (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 11 1 2 3 (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 4 participates. 5 6 The second exception to the general rule that rental real estate activities are per se passive 7 activities (and therefore subject to the disallowance 8 rule of section 469(a)) is found in section 469(i). 9 Under that provision, a taxpayer who "actively" 10 participates in a rental real estate activity may 11 deduct a maximum loss of $25,000 per year related to 12 the activity. See sec. 469(i) (1) and (2). This 13 exception is subject to phase-out when the taxpayer's 14 adjusted gross income (AGI) (determined without 15 regard to any passive activity loss) exceeds 16 17 $100,000. Sec. 469(i) (3). Two points about the application of passive 18 activity rules of section 469 are important to note 19 in deciding this case. The first is that, even if a 20 taxpayer would otherwise qualify as a real estate 21 professional under section 469(c) (7) (B), the taxpayer 22 must still "materially participate" in the taxpayer's 23 24 rental real estate activities in order to deduct losses associated with those activities. See Perez v. 25 Commissioner, T.C. Memo. 2010-232; see also (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 12 1 Shiekh v. Commissioner, T.C. Memo. 2010-126. 2 3 The second point to note is that, for purposes of determining whether a taxpayer is a real 4 estate professional, a taxpayer's material 5 participation is determined separately with respect 6 7 8 to each rental property, unless the taxpayer has made an explicit election to treat all interests in rental real estate as a single rental real estate activity. 9 Sec. 469 (c) (7 ) (A) ; Bailey v. Commis sioner, supra; sec. 10 11 12 1.469-9(c) (3), (e) (1), Income Tax Regs. X. Respondent concedes that Petitioner 13 actively participated in the Watersong House, and is 14 eligible under the second exception of section 469(i) 15 for the $25,000 offset for rental real estate 16 activities, discussed above. Petitioner, on the other 17 hand, maintains that he is a real estate professional 18 under section 469(c) (7) (B), the first exception, 19 discussed above, and, as such, he is entitled to 20 21 22 deduct the losses realized from the Watersong House in 2008 and 2009. At trial, Petitioner spent most of his time 23 detailing his activities with respect to the Gulfside 24 Motel property, not the Watersong House property, in 25 order to show that he qualified as a real estate (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 13 1 professional. Even if Petitioner qualifies as a real 2 estate professional under section 469(c) (7), however, 3 it is still necessary for Petitioner to show that he 4 materially participated in the Watersong House 5 activity. See Perez v. Commissioner, T.C. 6 Memo. 2010-232; Shiekh v. Commissioner, 7 T.C. Memo. 2010-126. 8 9 As to the material participation requirements, the unstated premise of Petitioner's 10 argument seems to be that all of his interests in 11 12 13 14 real estate are treated as one activity. To the contrary, however, section 469(c) (7) (A) (ii) provides that the exception for real estate professionals "shall be applied as if each interest of the taxpayer 15 in rental real estate were a separate activity", 16 unless the taxpayer elects to treat all interests in 17 rental real estate as one activity. At trial, 18 Petitioner was unable to show such election. He 19 stated that he had assumed that such an election was 20 filed, "but if we didn't, then that was a mistake." 21 We find that Petitioner did not elect to treat all 22 23 rental real estate interests as one activity, and that Watersong House must be treated as a separate 24 activity for purposes of determining whether 25 Petitioner materially participated in that activity. (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 Material participation is defined as 14 involvement in the operations of the activity that is regular, continuous, and substantial. Sec. 469(h) (1). An individual taxpayer materially 1 2 3 4 5 participates in an activity if he or she meets any 6 one of the following tests: (1) he or she 7 participates more than 500 hours during the year; (2) 8 his or her participation is substantially all of the 9 participation of individuals in that activity for the 10 11 year (including individuals who are not owners of interests in the activity); (3) he or she 12 participates more than 100 hours and no other 13 individual participated more; (4) the activity is a 14 significant participation activity and his or her 15 aggregate participation in all significant 16 participation activities exceeds 500 hours; (5) he or 17 18 she materially participates for 5 out of 10 years immediately preceding the year in issue; (6) the 19 activity is a personal service activity and he or she 20 materially participated for any 3 years preceding the 21 year in issue; or (7) on all the facts and 22 circumstances, he or she participated on a regular, 23 continuous, and substantial basis during the year. 24 Bailey v. Commissioner, T.C. Memo. 2001-296; Kosonen 25 v. Commissioner, T.C. Memo. 2000-107; sec. (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 1.469-5T(a), Temporary Income Tax Regs., 53 Fed.Reg. 15 5725 (Feb. 25, 1988). XI. Petitioner's activities with respect to 1 2 3 4 5 Watersong House in 2008 and 2009 amount to little 6 more than working with the builder of a subdivision 7 to purchase a luxury retirement home. Petitioner's 8 activities in this case are similar to the activities 9 performed by any number of retirees who move to a 10 retirement community, purchase a lot in a I I 11 subdivision, negotiate with a bank to obtain 12 financing, and negotiate with a builder for the 13 construction of a house, after making selections of 14 paint colors, floor coverings, and furniture from 15 among the options offered by the builder. We are 16 unwilling to find that the sum total of such 17 activities with respect to a single property, 18 constitutes material participation in a real estate 19 rental activity under the rules set forth in sec. 20 1.469-5T(a), Temporary Income Tax Regs., any more 21 than it would qualify the retiree, described above. 22 Indeed, when Petitioner wrote to 23 Respondent's counsel shortly before trial, he 24 25 esti'mated his time on Windsong House to be "30 hours in 2008 and 84 hours in 2009". We do not credit (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 16 1 Petitioner's testimony at trial that such amounts 2 should be 105 hours in 2008 and 134 hours in 2009. 3 There is no objective support for such increases in 4 the record of this case. Based upon our evaluation 5 of Petitioner's activities with respect to the 6 Windsong House, we find that he did not materially 7 participate in that activity during either 2008 or 2009. 8 9 10 XII. The other substantive issue in this case is 11 whether Petitioner is liable for the accuracy-related 12 penalty under section 6662 (a). Section 6662 (a) 13 imposes a penalty equal to 20 percent of any 14 underpayment of tax that is attributable to either 15 (1) negligence or disregard of rules or regulations 16 or (2) a substantial understatement of income tax. 17 18 See sec. 6662 (a), (b) (1) and (2) . The term "negligence" includes any failure 19 to make a reasonable attempt to comply with the 20 21 Internal Revenue Code, and the term "disregard" includes any careless, reckless, or intentional 22 disregard. Sec. 6662 (c). 23 24 An understatement of income tax is "substantial" if it exceeds the greater of 10 percent 25 of the tax required to be shown on the return, or (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 17 1 2 3 $5, 000 . Sec. 6662 (d) (1) (A) . As relevant herein, an "understatement" is defined as the excess of the tax required to be shown on the return over the tax 4 actually shown on the return. Sec. 6662 (d) (2) (A) . 5 Whether the accuracy-related penalty is 6 applied because of negligence or disregard of rules 7 8 9 or regulations or a substantial understatement of tax, the accuracy-related penalty does not apply to any portion of the underpayment if it is shown that 10 there was reasonable cause for the taxpayer's 11 position, and that the taxpayer acted in good faith 12 with respect to that portion. Sec. 6664 (c) (1); sec. 13 1.6664-4(b), Income Tax Regs.; see United States v. 14 Boyle, 469 U.S. 241, 242 (1985). 15 16 17 Section 7491 (c) places on the Commissioner the burden of production with respect to a taxpayer's liability for a penalty such as the accuracy-related 18 penalty under section 6662 (a) . However, the ultimate 19 burden of persuasion remains on the taxpayer. Swain 20 v. Commissioner, 118 T.C. 358, 363 (2002); Higbee v. 21 Commissioner, 116 T.C. 438, 446-448 (2001); see Rule 22 142(a). Respondent satisfied his burden of 23 production under section 7491(c) because the record 24 convincingly demonstrates that Petitioner 25 substantially understated his income tax for 2008 and (866) 448 - DEPO www.CapitalReportingCompany.com 2012 Capital Reporting Company Paul E. Phillips 09-13-2012 18 1 2 3 4 5 2009. In contrast, Petitioner failed to satisfy his burden. Petitioners did not address this issue at trial and, thus, thcy failed to show any reason why t-l+e-y- should not be held liable for that penalty. See sec. 6664 (c) (1). Accordingly, we sustain 6 Respondent's determination of the accuracy-related 7 penalty under section 6662 (a) for taxable year 2008 8 9 10 and 2009. XIII. To give effect to the above, decision will 11 be entered for Respondent. 12 13 XV. (Whereupon, THIS CONCLUDES THE COURT'S ORAL 14 FINDINGS OF FACT AND OPINION IN THIS CASE.) 15 16 17 18 19 20 21 22 23 24 25 (866) 448 - DEPO www.CapitalReportingCompany.com 2012