TAX COURT OPINION

Case: Michael G. Varner & Melissa A. Varner
Docket Number: 23338-14S
Judge: Marvel
Opinion Type: bench
Filed: 07/09/2015
Pages: 14

SYM UNITED STATES TAX COURT WASHINGTON, DC 20217 MICHAEL G. VARNER & MELISSA A. VARNER, Petitioner(s), v. ) ) ) ) ) ) Docket No. 23338-14S COMMISSIONER OF INTERNAL REVENUE, Respondent. ) ) ) ) ORDER Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit to petitioners and to respondent a copy of the pages of the transcript of the proceedings of the above case before Judge L. Paige Marvel at Knoxville, Tennessee, on June 24, 2015, containing the Court's oral findings of fact and opinion. In accordance with the oral findings of fact and opinion, decision will be entered for respondent as to the deficiency and for petitioners as to the accuracyrelated penalty under section 6662(a). (Signed) L. Paige Marvel Judge Dated: Washington, D.C. July 9, 2015 SERVED Jul 10 2015 Capital Reporting Company 3 1 2 Bench Opinion by Judge L. Paige Marvel June 24, 2015 3 Michael G. Varner and Melissa A. Varner v. 4 5 6 7 8 9 10 11 12 13 14 Commissioner Docket No. 23338-14S 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. THE ORAL FINDINGS OF FACT AND OPINION SHALL NOT BE RELIED UPON AS PRECEDENT IN ANY OTHER CASE. This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code of 1986 as amended, and Rules 170 through 174 of the Tax 15 Court Rules of Practice and Procedure. Pursuant to 16 17 18 19 20 21 22 23 24 25 section 7463(b), the decision to be entered is not reviewable by any other court, and this bench opinion shall not be treated as precedent for any other case. This bench opinion is made pursuant to the authority granted by section 7459(b) of the Internal Revenue Code of 1986 as amended and Rule 152 of the Tax Court Rules of Practice and Procedure. Unless otherwise indicated, subsequent section references made in this bench opinion are to the Internal Revenue Code of 1986 as amended in effect for the tax 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 4 1 2 3 year in issue, and Rule references are to the Tax Court Rules of Practice and Procedure. Petitioners Michael Varner (Mr. Varner) and 4 Melissa Varner (Ms. Varner) appeared pro sese. Amber 5 B. Martin appeared on behalf of respondent. 6 Petitioners petitioned this Court after respondent 7 8 9 issued them a notice of deficiency disallowing a rental real estate loss deduction that they claimed on their joint Federal income tax return for taxable 10 year 2011. The two issues we must decide are: (1) 11 whether petitioners are entitled to deduct a rental 12 real estate loss in the amount of $23,613; and (2) 13 whether petitioners are liable for an accuracy- 14 15 16 17 18 19 20 21 22 23 24 25 related penalty under section 6662(a). FINDINGS OF FACT Some of the facts have been stipulated. The stipulations of fact are incorporated herein by this reference. When they petitioned this Court, petitioners resided in Tennessee. Petitioners owned rental real estate in 2011. On a Schedule E, Supplemental Income and.Loss, attached to their joint 2011 Federal income tax return, they reported a $23,613 loss with respect to the rental real estate activity and claimed a corresponding deduction. Petitioners' adjusted gross 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 5 income (AGI) for 2011 was $174,683. Respondent conducted an examination of petitioners' 2011 tax year. In a notice of deficiency dated July 25, 2014, respondent determined that petitioners qualified as active participants in the rental real estate business but were not entitled to the claimed deduction because their modified AGI exceeded the statutory threshold. Petitioners counter by claiming that Ms. Varner was a taxpayer engaged in a real property business (real estate professional) within the meaning of section 469(c)(7) and that the phaseout rule does not apply to limit their real estate loss deduction. OPINION Generally, the Commissioner's determination of a deficiency is presumed correct, and a taxpayer has the burden of proving it incorrect. Rule 142(a); 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Welch v. Helvering, 290 U.S. 111, 115 (1933). In 19 20 21 22 23 24 25 addition, a taxpayer ordinarily bears the burden of proving that he or she is entitled to a claimed deduction. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). A taxpayer is required to maintain records to substantiate claimed deductions and to establish his or her correct tax liability. Higbee v. Commissioner, 116 T.C. 438, 440 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 6 (2001); see also sec. 6001. The taxpayer must produce such records upon the request of the Secretary. Sec. 7602(a); see also sec. 1.6001-1(e), Income Tax Regs. The burden of proof on a factual issue that affects a taxpayer's liability for tax may be shifted to the Commissioner where the "taxpayer introduces credible evidence with respect to * * * such issue." Sec. 7491(a)(1). Petitioners have neither claimed nor shown that they complied with the substantiation requirements of section 7491(a). Therefore, the burden of proof remains on petitioners. See Rule 142(a). Taxpayers are allowed deductions for certain business and investment expenses pursuant to sections 162 and 212. However, section 469 generally disallows any passive activity loss for a taxpayer's tax year. .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 defined as the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for such year. Sec. 469(d)(1). A rental activity is 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 generally treated as a per se passive activity 866.488.DEPO www.CapitalReportingCompany.com 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Capital Reporting Company 7 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). There are two relevant exceptions to the general rule of section 469(a) and they are found in section 469(c)(7) and section 469(i). Pursuant to section 469(c)(7), the real estate activities of a taxpayer who is a real estate professional are not per se passive activities but are treated as a trade or business subject to the material participation requirements of section 469(c)(1). Sec. 1.469- 9(e)(1), Income Tax Regs. A taxpayer qualifies as a real estate professional and is not engaged in a passive activity under section 469(c)(2) 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 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 8 year in real property trades or businesses in which the taxpayer materially participates [750-hour service performance requirement]. Sec. 469(c)(7)(B). In the case of a joint return, the foregoing requirements for qualification as a real estate professional are satisfied if, and only if, either spouse separately satisfies the requirements. Id. Thus, if either spouse qualifies as a real estate professional the real estate 1 2 3 4 5 6 7 8 9 10 11 12 activities of the real estate professional are not 13 14 15 16 17 18 19 20 21 22 23 24 per se passive under section 469(c)(2). A taxpayer may prove that he or she met the 750- hour service performance requirement by any reasonable means, including "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." Section 1.469-ST(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). However, the regulations require more than a "ballpark guesstimate". Moss v. Commissioner, 135 T.C. 365, 369 (2010) (quoting 25 Bailey v. Commissioner, T.C. Memo. 2001-296). 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 9 1 2 3 4 5 6 7 8 9 Petitioners contend that Ms. Varner qualified as a real estate professional for 2011 and that they may therefore use the rental real estate loss to offset their nonpassive income. In support of their contention, petitioners introduced into evidence various documents including a handwritten log, prepared by Mr. Varner ostensibly from information furnished to him by Ms. Varner, and a typed log allegedly based on the handwritten log but amplifying 10 the description of work performed by Ms. Varner that 11 Mr. Varner prepared shortly before trial. The 12 13 14 15 16 17 18 19 20 21 22 23 24 documentation introduced by petitioners also included a few invoices but most of those invoices were for items and services purchased in years other than 2011. While we have no doubt that Ms. Varner dabbled in real estate activities in addition to petitioners' rental real estate activity during 2011, the testimony and documentation offered by petitioners was insufficient to establish that Ms. Varner was operating as a real estate professional during 2011. Although Ms. Varner was a licensed real estate agent before 2011, her real estate license was inactive at the beginning of 2011 and she changed her designation 25 to retired status in January 2011. Ms. Varner 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 10 1 2 3 4 5 6 7 8 9 10 11 testified that she attended many auctions during 2011 but she did not purchase, sell, renovate or flip any property during that year. Much of the time she claimed to have spent on her real estate activities consisted of reviewing the real estate section of the local newspaper, engaging in research that was only vaguely described in testimony, looking at properties that she did not buy or sell, and updating computer databases. However, some of the time she claimed to have spent on such things as updating databases appears to have been time properly attributable to 12 Mr. Varner, the one who maintained the computer 13 14 databases. The other activities on which Ms. Varner claimed to have spent time appear to be excessive 15 without more detail and were simply not convincing. 16 While we do accept as credible Ms. Varner's testimony 17 18 19 20 21 22 23 24 25 that she processed rental checks each month and performed some work with respect to petitioners' three rental properties, that part of the testimony and documentation we find credible is not sufficient to prove that Ms. Varner devoted the required time to an existing real estate business to qualify as a real estate professional during 2011. Because petitioners have failed to prove that Ms. Varner was working as a real estate professional in 2011, her real estate 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 11 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 activities in 2011 do not qualify for the section 469(c) (7) exception. We turn now to the second exception. Section 469(i)(1) provides a limited exception to the rule that passive activity losses are disallowed. A taxpayer who actively participates in a rental real estate activity may deduct a maximum loss of up to $25,000 per year related to the activity. Sec. 469(i)(1) and (2). The deduction is phased out as AGI exceeds $100,000, with a full phaseout occurring when modified AGI equals $150,000. Sec. 469(i)(3) (A). As used here, AGI is calculated without reference to "any passive activity loss or any loss allowable by reason of subsection (c)(7)" (modified AGI). Sec. 469(i)(3)(F)(iv). Respondent determined that Ms. Varner actively participated in petitioners' rental real estate 18 activity in 2011. Petitioners are precluded from 19 20 21 22 23 24 taking advantage of the section 469(i)(1) exception, however, because their modified AGI exceeded $150,000 and they are therefore subject to the phaseout. Petitioners therefore do not qualify for an exception to the passive activity loss rules under section 469(a). Petitioners' rental real estate 25 activity produced a passive activity loss for 2011 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 12 that petitioners may not use to offset income from nonpassive activities. We sustain respondent's determination with respect to the rental real estate loss deduction. We turn now to the section 6662 accuracy-related penalty. Pursuant to section 6662(a) and (b)(2), a taxpayer may be liable for a penalty of 20% on the portion of an underpayment of tax that is attributable to, among other things, a substantial understatement of income tax. "Understatement" means the excess of the amount of the tax required to be shown on the return over the amount of the tax imposed which is shown on the return, reduced by any rebate. Sec. 6662(d)(2) (A). A "substantial understatement" of income tax is defined as an understatement of tax that exceeds the greater of 10% of the tax required to be shown on the tax return or $5,000. Sec. 6662(d)(1) (A). The understatement is reduced to the extent that the taxpayer has: (1) adequately disclosed his position and has a reasonable basis for such position, or (2) has substantial authority for the tax treatment of the item. Sec. 6662(d)(2) (B). With regard to the accuracy-related penalty, respondent bears the burden of production pursuant to section 7491(c), and 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 13 1 2 3 4 petitioners bear the burden of proof. See Higbee v. Commissioner, 116 T.C. at 446. The accuracy-related penalty is not imposed with respect to any portion of the underpayment as to 5 which the taxpayer acted with reasonable cause and in 6 7 8 9 10 11 12 13 14 good faith. Sec. 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith depends upon all of the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant factors include the taxpayer's efforts to assess his or her proper tax liability, including the taxpayer's reasonable and good faith reliance on the advice of a professional such as an accountant. Id. Furthermore, an honest 15 misunderstanding of fact or law that is reasonable in 16 17 18 19 20 21 22 23 24 25 the light of the experience, knowledge, and education of the taxpayer may indicate reasonable cause and good faith. Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners' understatement is greater than $5,000 and greater than 10% of the tax required to be shown on the tax return. See sec. 6662(b) (2), (d)(1) (A). Therefore, we hold that respondent has met his burden of production regarding the accuracy-related penalty pursuant to section 6662(a). We decline to impose the section 6662 penalty, 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 14 1 2 3 however, because petitioners have convinced us that they had reasonable cause for their understatement and that they acted in good faith. Despite the 4 Court's problems in ascertaining whether Ms. Varner 5 6 7 qualified as a real estate professional from the evidence in the record, petitioners maintained records of their and Ms. Varner's real estate 8 activities that they believed to be sufficient proof 9 of the time and attention devoted to the activity by 10 Ms. Varner during 2011. Although the records, 11 particularly the handwritten log, lacked adequate 12 13 14 15 16 17 18 19 20 21 22 23 24 25 detail to make them convincing, the Court may have reached a different result if it had found those records to be fully credible. We conclude that petitioners are not liable for the section 6662 penalty. We have considered the parties' remaining arguments and, to the extent not discussed above, conclude that those arguments are irrelevant, moot, or without merit. To reflect the foregoing, decision will be entered for respondent as to the income tax deficiency and for petitioners with respect to the section 6662 accuracy-related penalty. THIS CONCLUDES THE COURT'S ORAL FINDINGS OF FACT 866.488.DEPO www.Capita1ReportingCompany.com Capital Reporting Company 15 AND OPINION IN THIS CASE. (Whereupon, at 10:44 a.m., the above- entitled matter was concluded.) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 866.488.DEPO www.CapitalReportingCompany.com