TAX COURT OPINION

Case: Gladstone Alden Dainty
Docket Number: 11076-12
Judge: Gustafson
Opinion Type: bench
Filed: 06/20/2013
Pages: 14

SEC UNITED STATES TAX COURT WASHINGTON, DC 20217 GLADSTONE ALDEN DAINTY, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent ) ) ) ) ) Docket No. 11076-12. ) ) ) ) OR D E R Pursuant to the opinion of the Court as set forth in the pages of the transcript of the proceedings before Judge David Gustafson at Washington, D.C., on June 7, 2013, containing his oral findings of fact and opinion, 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 trial in the above case before Judge Gustafson at Washington, D.C., containing his oral findings of fact and opinion rendered at the trial session at which the case was heard. In accordance with the oral findings of fact and opinion, decision will be entered under Rule 155. (Signed) David Gustafson Judge Dated: Washington, D.C. June 20, 2013 SERVED Jun 20 2013 Capital Reporting Company 3 1 2 Bench Opinion by Judge David Gustafson June 7, 2013 3 Gladstone Alden Dainty v. Commissioner 4 5 6 Docket No. 11076-12 THE COURT: The Court has decided to render the following as its oral Findings of Fact and 7 Opinion in this case. This Bench Opinion is made 8 9 10 11 12 13 14 pursuant to the authority granted by section 7459(b) of the Internal Revenue Code, and Rule 152 of the Tax Court Rules of Practice and Procedure; and it shall not be relied on as precedent in any other case. By notice of deficiency dated February 3, 2012, the Internal Revenue Service (IRS) determined a deficiency in the Federal income tax of petitioner 15 Gladstone Alden Dainty for the year 2008, along with 16 17 18 19 20 21 22 23 24 25 an accuracy-related penalty under section 6662(a). The principal issue for decision is whether real estate losses claimed by Mr. Dainty are limited by section 469 -- an issue that depends largely on whether he is a real estate professional for purposes of section 469(c) (7). For the reasons explained hereafter, we hold that he did not prove that he is a real estate professional, and we largely sustain the IRS's determinations. Trial of this case was conducted on June 5, 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 4 1 2 3 4 5 6 2013, in Washington, D.C. Mr. Dainty represented himself; and William J. Gregg and Andrew K. Glover represented respondent. The parties' Stipulation of Facts was admitted into evidence, along with the attached Exhibits. We find the following facts: · FINDINGS OF FACT 7 Mr. Dainty's background 8 9 10 11 12 13 14 Mr. Dainty has been a hard-working man all his life. He worked his way through college, graduating in 1977 when he was in his mid-20s. He thereafter took courses in an MBA program, worked in · the insurance business, and did various other jobs, including tax return preparation. In 1992 he received his license as a Certified Public Accountant. 15 Mr. Dainty's activities 16 17 18 19 20 21 22 23 24 25 In 2008 Mr. Dainty was engaged in two principal money-making activities: First, Mr. Dainty provided accounting and bookkeeping services, consulting services, and tax return preparation services under the name "Gladstone A. Dainty & Associates". In 2008 this business generated gross receipts of $467,390. About $280,000 of those receipts were paid under a contract with Federal Management Systems, Inc., at a rate of $187.50 per hour (for about 1,500 hours). During the 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 5 1 2 3 4 5 6 7 8 9 2008 filing season, this business also prepared 136 tax returns, all under Mr. Dainty's preparer tax identification number ("PTIN"). In this business Mr. Dainty employed consultants (usually two at any given time) who were paid a total of $116,789 in 2008. Mr. Dainty did not present logs or time records to show the hours worked by himself or those other consultants; and on the scant evidence presented (chiefly, Mr. Dainty's own 10 summary testimony) we are able to determine neither 11 12 13 14 15 16 17 18 the hours that Mr. Dainty worked nor the extent to which the revenue of the business was derived from services performed by Mr. Dainty himself or by the other workers. Second, Mr. Dainty owned and managed nine properties in Maryland and the District of Columbia. He performed such tasks as making and arranging repairs, finding tenants, collecting rent, paying 19 bills, and handling disputes with tenants and taxing 20 21 22 23 24 25 authorities. He substantially renovated one property, using subcontractors and doing some work himself. He must have spent considerable time on these efforts; but he kept no log or other record of his time spent, and the only evidence of the amount of time he spent was his own very general testimony. 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 6 1 2 3 We are unable to determine the amount of time he spent on these real-estate-related activities. In particular, Mr. Dainty did not prove that in 2008 4 more than half of the services he performed in trades 5 6 7 8 9 10 11 or businesses were performed in his real estate businesses, nor that he performed more than 750 hours in those businesses. With.respect to one of his nine properties (at 3402 Lancer Drive), Mr. Dainty was granted forgiveness of a mortgage debt in the amount of $32,371, and he was issued a Form 1099 by the lender. 12 Mr. Dainty's tax return 13 14 15 16 17 18 19 20 21 22 23 24 25 Mr. Dainty filed his Federal income tax return for taxable year 2008 in October 2009 after having received an extension, and we assume the return was timely. His return included a Schedule C, "Profit or Loss from Business",. for his CPA business, a Schedule C on which he reported a modest amount of income generated by insurance business activity in a prior year, and a Schedule C on which he reported the forgiveness of indebtedness. The form for Schedule E, "Supplemental Income and Loss", has three columns for three properties, and Mr. Dainty included with his return three Schedules E reporting information for nine 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 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 properties. With one exception (forgiveness of debt described below), Mr. Dainty reported income and deductions for each separate property in its own column; he reported the separate loss for each property on line 22 of Schedule E; and hc carried the cn lin: 22 of --Sehedttbe-E and he carried those amounts down to line 23 and reported them as a separate "Deductible rental real estate loss" for each property. He carried these losses over to line 17 on his Form 1040, where they were subtracted from his other income and had the effect of reducing his reported tax liability. The entry for line 23 on the form states, "Caution: Your rental real estate loss on line 22 may be limited... Real estate professionals must complete line 43 on page 2." Line 43 on page 2 is entitled "Reconciliation for real estate professionals." Mr. Dainty did not include page 2 of Schedule E with his Form 1040 for 2008. Page E-2 of the instructions for Schedule E states as follows: "For purposes of this rule [i.e. the passive activity loss rule), each interest in real estate is a separate activity, unless you elect to treat all your interests in rental real estate as one activity. To make this election, attach a 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 8 statement to your original tax return that declares you are a qualifying taxpayer for the year and you are making the election under section 469(c) (7) (A)." In the column on Schedule E for the property on 3402 Lancer Drive, Mr. Dainty did not report the $32,371 of forgiveness-of-indebtedness income generated by the mortgage of that property. Instead, as income he reported only $1,800 in rent and, after expenses, a loss of $14,124. If he had reported the forgiveness of debt income on Schedule E, then that income would have offset the expenses and the property would have generated income and not a loss. IRS examination The IRS selected Mr. Dainty's 2008 tax return for examination. After the conclusion of the examination, the IRS disallowed the losses claimed from the real estate activity and issued on February 3, 2012, the statutory notice of deficiency. In that notice the IRS determined a deficiency of tax and an accuracy-related penalty under section 6662(a). On May 3, 2012, Mr. Dainty timely filed his petition in this Court challenging the IRS's determinations. At that time he resided in Maryland. 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 9 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 I. Burden of proof OPINION The IRS's determination is presumed correct, and the taxpayer generally bears the burden to prove his entitlement to any deductions he claims. Rule 142(a). Deductions are a matter of legislative grace, and taxpayers must satisfy the specific requirements for any deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Furthermore, taxpayers are required to maintain records sufficient to substantiate their claimed deductions. See sec. 6001; 26 C.F.R. sec. 1.6001- 1(a); see also id. sec. -1(e) ("The books or records * * * shall be retained so long as the contents thereof may become material in the administration of any internal revenue law"). Mr. Dainty evidently failed in many respects to keep records that might have substantiated (or might have disproved) his entitlement to real estate professional status and, thereby, to the losses he attempted to deduct. II. Real estate losses Taxpayers are allowed deductions for certain business and investment expenses under sections 162 and 212. Section 469, however, 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 10 1 2 3 4 5 6 7 8 generally disallows any passive activity loss. A passive activity is any trade or business in which the taxpayer does not materially participate. Sec. 469(c) (1). Material participation is defined as involvement in the operations of the activity that is regular, continuous, and substantial. Sec. 469(h) (1). However, rental activity is generally treated as a per se passive activity regardless of 9 whether the taxpayer materially participa.tes. Sec. 10 11 469(c) (2), (4). An exception to the rule that a rental 12 activity is per se passive is found in section 13 14 15 16 17 18 19 20 21 22 23 469(c) (7), which provides that the rental activities of a taxpayer in real property trades or businesses are not per se passive activities under section 469(c) (2) but are treated as a trade or business subject to the material participation requirements of section 469(c) (1), provided that the taxpayer qualifies as a real estate professional. He will so qualify if: (1) more than onelhalf of the personal services performed in trades or businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the 24 · taxpayer materially participates, and (2) the 25 taxpayer performs more than 750 hours of services 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 18 19 20 21 22 23 24 during the taxable year in real property trades or businesses in which the taxpayer materially participates. Sec. 469(c) (7) (B) (i) and (ii). With respect to the evidence that may be used to establish hours of participation, section 1.469-5T(f) (4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), provides: "The extent of an individual's participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph 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." Mr. Dainty has no documentary evidence to show the quantum of his real estate activities but relies instead on his very general testimony giving his estimate that he worked 80 hours a week total and less than 30 hours of that on non-real-estate 25 activity. The regulation quoted above does not allow 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 12 1 2 3 4 a party to rely on a postevent "ballpark guesstimate" or unverified, undocumented testimony, see Moss v. Commissioner, 135 T.C. 365, 369 (2010); and we are not persuaded by this testimony. His non-real-estate 5 activities were very substantial, and they appear to 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 constitute his regular full-time job, with the real estate activity as a substantial but unquantifiable side activity. Because we are no persuaded that Mr. Dainty spent more time on his real estate activities in 2008 than he spent on his other work, nor that he spent 750 hours on his real estate activities, he has not established that he is a real estate professional. His real estate activities are therefore per se passive, and he may not offset the losses against his other income. If he had established that he is a real estate professional, Mr. Dainty would then face the issue that he did not elect (pursuant to section 469(c) (7) (A)) to aggregate his properties into a single activity, so even then he would need to show "material participation" with respect to each of the properties -- an undertaking he as much as admitted he is unable to do. But, again, we need not reach this issue, because he did not show that he is a real 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 13 1 2 3 4 5 estate professional, and his real estate activities are therefore per se passive. However, it appears that Mr. Dainty was entitled to deduct his passive losses to the extent of the forgiveness-of-indebtedness income that 6 Mr. Dainty realized in 2008 on the Lancer Drive 7 8 9 10 11 property, but the IRS made no such adjustment in the notice of deficiency. A "passive activity loss" is defined as the amount which "the aggregate losses from all passive activities for the taxable year, exceed * * * the aggregate income from all passive 12 activities for such year." Sec. 469(d) (1); see 13 14 15 16 17 18 19 20 21 22 23 24 25 Schwalbach v. Commissioner, 111 T.C. 215, 223 (1998). In Revenue Ruling 92-92, 1992-2 C.B. 103, the IRS states that cancellation of indebtedness Income 1s "characterized as income from a passive activity to the extent that, at the time the indebtedness is discharged, the debt is allocated to passive activity expenditures". Mr. Dainty's Lancer Drive debt was allocable to his passive renting activity, so his forgivene.ss-of-indebtedness income arising from that debt is passive activity income and can be offset by his losses from his passive activities. Mr. Dainty's liability should therefore be recomputed with this allowance. 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 14 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 III. Accuracy-related penalty Section 6662 1mposes an "accuracy-related penalty" of 20 percent of the portion of the underpayment of tax that is attributable to the taxpayer's negligence or disregard of rules or regulations or that is attributable to any substantial understatement of tax. The precise amount of the 2008 understatement that will result from the adjustments that we have sustained is yet to be determined pursuant to Rule 155, but it seems clear that it will be "substantial" under section 6662 (d) -- i.e., that it will exceed both $5,000 and 10 percent of the tax that should have been reported. We therefore need not reach the issue of negligence. . Mr. Dainty cannot successfully invoke any of the defenses that a taxpayer might assert against an accuracy-related penalty: He had no "substantial authority" for this position (see sec. 662(d) (2) (B)); he did not disclose on his return (see sec. 6662 (d) (2) (B)) that he could not show the quantum of his time spent on the real estate activities; and he did not show reasonable cause and good faith for his erroneous reporting (see sec. 6664 (c) (1)). This third potential defense might be available if the evidence showed, for example, that it was a close 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 1 2 3 call whether Mr. Dainty's hours spent in real-estate- related activity were sufficient to qualify him as a real estate professional. Instead, there was a 4 wholesale failure to make a showing of the hours 15 spent, and we cannot find "reasonable cause" and "good faith" in that circumstance. We therefore hold that Mr. Dainty is liable for the accuracy-related penalty for 2008. . So that the liability can be recalculated, decision will be entered pursuant to Rule 155. This concludes the Court's oral Findings of Fact and Opinion in this case. (Whereupon, at 12:16 p.m., the above- entïtled matter was concluded. ) 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