TAX COURT OPINION

Case: Jeffry J. Kennedy & Linda S. Kennedy
Docket Number: 5051-11
Judge: Marvel
Opinion Type: bench
Filed: 06/06/2013
Pages: 18

UNITED STATES TAX COURT WASHINGTON, DC 20217 JEFFRY J. KENNEDY & LINDA S. KENNEDY, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. KVC ) ) ) ) ) ) Docket No. 5051-11 ) ) ) ) ) OR D E R 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 Jacksonville, Florida, on May 24, 2013, containing her oral findings of fact and opinion. In accordance with the oral findings and fact and opinion, a decision will be entered for respondent with respect to the deficiencies and for petitioners with respect to the I.R.C. § 6662 accuracy-related penalties. (Signed) L. Paige Marvel Judge Dated: Washington, D.C. June 6, 2013 SERVED Jun 07 2013 Capital Reporting Company Bench Opinion by Judge L. Paige Marvel May 24, 2013 Jeff J. Kennedy & Linda ¡¡. Kennedy v. Commissioner Docket No. 5051-11 3 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 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. Hereinafter in this bench opinion, unless otherwise indicated, section references are to the Internal Revenue Code of 1986 (Code) as amended and in effect for the years in issue. Rule references are to the Tax Court Rules of Practice and Procedure. Some monetary amounts have been rounded to the nearest dollar. Jeffry J. Kennedy appeared pro se. Linda S. Kennedy did not appear but previously authorized 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 Mr. Kennedy to represent her interests at trial. 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 4 1 Christopher A. Pavilonis appeared on behalf of 2 3 4 5 6 7 8 9 10 11 respondent. Mr. Kennedy and Mrs. Kennedy, who are divorced, resided in Florida when they petitioned this Court. In a notice of deficiency dated November 30, 2010, respondent determined deficiencies in Mr. and Mrs. Kennedy's Federal income tax of $16,612 and $43,637 for 2006 and 2007, respectively, and accuracy-related penalties under section 6662(a) of $3,322 and $8,727 for 2006 and 2007, respectively. The issues for decision are: (1) whether 12 Mr. and Mrs. Kennedy are entitled to home mortgage 13 14 15 interest deductions claimed on their Schedules A, Itemized Deductions, for 2006 and 2007 in excess of the amount allowed by respondent; (2) whether Mr. and 16 Mrs. Kennedy failed to report additional income of 17 18 19 20 21 22 $1,000 for 2007; and (3) whether Mr. and Mrs. Kennedy are liable for accuracy-related penalties under section 6662(a) for 2006 and 2007. Facts Some of the facts have been deemed established for purposes of this case in accordance 23 with Rule 91(f). Mr. Kennedy and respondent also 24 25 executed a stipulation of facts. The stipulated facts are incorporated herein by this reference. 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 5 1 2 During the years in issue Mr. Kennedy was employed full-time as an operations manager at 3 Sullivan Pontiac GMC Truck (Sullivan Pontiac), a 4 5 6 7 8 9 10 11 12 company that owned and operated six car dealerships. On November 28, 2005, petitioners acquired property in Windermere, Florida (Windermere property) for $2,125,000. They purchased the Windermere property with the intention of making improvements to the property and then reselling it for a profit. They apparently financed the purchase with several loans secured by the Windermere property, and during the years at issue had outstanding mortgage loans 13 with GMAC, Mercantile Bank, and Wells Fargo. During 14 2006 the mortgage loans with respect to the 15 Windermere property had an average monthly loan 16 17 18 19 balance of $2,650,885. During 2007 the mortgage loans with respect to the Windermere property had an average monthly loan balance of $3,573,401. When petitioners first acquired the 20 Windermere property in 2005, it was in terrible 21 22 shape. Petitioners began the process of rehabbing the property and that process continued into 2006. 23 Mr. Kennedy and others worked on the reconstruction 24 25 of the Windermere property during 2005 and 2006 although he did not keep any log or calendar 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 6 1 2 3 4 documenting the time that he spent. Petitioners had decided to reside in Naples, Florida. They initially rented a home in Naples and eventually began constructing a house in 5 Naples. Because of delays in the construction of the 6 Naples house, Mr. Kennedy began residing at the 7 Windermere property in early 2006 and stayed there 8 until sometime in May or June 2007. Ms. Kennedy and 9 petitioners' son also moved to the Windermere 10 property sometime in 2006. For each of 2006 and 2007 11 Mr. and Mrs. Kennedy applied for and received a 12 13 14 15 16 17 18 19 20 21 22 23 24 25 homestead exemption for the Windermere property from the Orange County Property Appraiser. In approximately May or June 2007, Mr. Kennedy moved out of the Windermere property and listed the property for sale. When the Windermere property did not sell, petitioners attempted to rent it. A prospective tenant made a nonrefundable deposit of $1,000 but never finalized a lease and did not move into the Windermere property. Mr. and Mrs. Kennedy filed joint Forms 1040, U.S. Individual Income Tax Return, for 2006 and 2007. On their Forms 1040 they listed the Windermere address as their current home. On Schedules A attached to their returns Mr. and Mrs. Kennedy claimed deductions for 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 7 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 home mortgage interest of $159,153 and $187,319 for 2006 and 2007, respectively. On October 29, 2009, Mr. and Mrs. Kennedy filed a joint Form 1040X, Amended U.S. Individual Income Tax Return, for 2007. On the Form 1040X they listed an address in Naples, Florida as their current home. On an attached Schedule A Mr. and Mrs. Kennedy claimed a deduction for home mortgage interest of $67,661. On an attached Schedule E, Supplemental Income and Loss, Mr. and Mrs. Kennedy reported that the Windermere property was rental real estate and they incurred a loss of $144,007 with respect to the property. They reported that they received rent of $1,000 and claimed business expenses of $145,007, including mortgage interest of $114,704 and taxes of $30,303. Respondent subsequently issued the notice of deficiency for 2006 and 2007. In the notice of deficiency respondent disallowed $93,111 and $131,935 of the home mortgage interest deductions Mr. and Mrs. Kennedy claimed on the Schedules A attached to their Forms 1040 for 2006 and 2007, respectively. Respondent determined that Mr. and Mrs. Kennedy had failed to report other income of $1,000, the amount of the nonrefundable deposit, for 2007. Respondent 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company also determined that Mr. and Mrs. Kennedy were liable for section 6662(a) accuracy-related penalties for 2006 and 2007 because they substantially understated 8 their income tax liabilities. Home Mortgage Interest Deductions Generally, the Commissioner's determinations in a notice of deficiency are presumed correct. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Deductions are a matter of legislative grace, and a taxpayer ordinarily must prove that he is entitled to the claimed deduction. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Section 163(a) provides the general rule that there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. However, section 163(h) (1) provides that in the case of a taxpayer other than a corporation, no deduction shall be allowed for personal interest which is paid or accrued during the taxable year. Pursuant to section 163(h) (2), personal interest does not include interest which is investment interest, interest which is taken into account under section 469 in computing income or loss from a passive activity of the taxpayer (passive 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 1 activity interest), or qualified residence interest. 9 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Qualified Residence Interest Generally, a taxpayer is entitled to claim a home mortgage interest deduction if he paid or accrued interest on indebtedness with respect to a qualified residence. See sec. 163(h) (3) (A). A "qualified residence" is defined as the taxpayer's principal residence, within the meaning of section 121, and one other residence that the taxpayer used as a residence during the taxable year. See sec. 163(h) (4) (A) (i) (I) and (II). Section 163(h) (3) (A) defines qualified residence interest as any interest which is paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. The term acquisition indebtedness includes any indebtedness which is secured by a qualified residence and which is incurred in acquiring, constructing, or substantially improving such residence. See sec. 163 (h) (3) (B) (i). Pursuant to section 163(h), married individuals filing joint returns may not deduct interest paid on acquisition indebtedness and home equity indebtedness to the extent that the indebtedness 1s 1n excess of the limitations provided 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 10 1 by section 163(h) (3) (B) (ii) and (C) (ii). 2 Specifically, section 163(h) (3) (B) (ii) provides that 3 4 5 6 7 8 9 "[t]he aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000". Section 163(h) (3) (C) (ii) provides that "[t]he aggregate amount treated as home equity indebtedness for any period shall not exceed $100,000". Petitioners owned and resided in the 10 Windermere property for at least part of the time 11 12 during 2006 and 2007. They applied for, and received, homestead exemptions with respect to the 13 Windermere property for 2006 and 2007. In 2006 and 14 15 16 17 18 19 2007 Sullivan Pontiac and John Hancock Life Insurance Co. mailed information returns regarding Mr. Kennedy's wages and individual retirement account distributions to him at the Windermere address. The record contains copies of Mr. and Mrs. Kennedy's Forms 1040 for 2006 and 2007, both of which list the 20 Windermere address as their home address. 21 Accordingly, we find that the Windermere property was 22 23 a qualified residence of Mr. and Mrs. Kennedy. Mr. and Mrs. Kennedy's deduction for home 24 mortgage interest under section 163(h) is limited by 25 section 163(h) (3) (B) (ii) and (C) (ii), discussed 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 11 supra. On the 2006 and 2007 Schedules A of their original returns, petitioners claimed deductions for home mortgage interest in excess of the limitations imposed by the Code. In the notice of deficiency respondent allowed petitioners the maximum amounts of home mortgage interest in determining their allowable deductions for 2006 and 2007. Accordingly, we sustain respondent's determination disallowing the $93,111 and $131,935 of home mortgage interest deductions Mr. and Mrs. Kennedy claimed on the Schedules A attached to their Forms 1040 for 2006 and 2007, respectively. Passive Activity Interest Mr. Kennedy contends that the home mortgage interest paid on the Windermere residence is not limited by section 163(h) (3) because he was a real estate professional during the years in issue. He further contends that he may deduct the home mortgage interest as expense incurred in a trade or business. While generally a taxpayer may deduct a loss incurred in a trade or business, see sec. 165(c) (1), a taxpayer may not deduct a loss from a passive activity, see sec. 469(a). A passive activity loss is defined as the excess, if any, of the aggregate losses from passive activities during a 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 12 1 taxable year over the a.ggregate income from passive 2 activities for such year. Sec. 469(d) (1). Interest 3 4 5 6 7 allocated to a passive activity within the meaning of section 469 will be taken into account in determining the income or loss from such activity and, therefore, is not subject to the limitations of section 163(h). Sec. 163(h) (2) (C). However, the interest expense 8 will be subject to possible disallowance under the 9 passive activity loss limitation of section 469. In 10 11 12 13 14 15 order to calculate a taxpayer's passive activity loss for a taxable year, the taxpayer must ascertain whether the taxpayer's income and losses are from passive activities in accordance with rules set forth in section 469 and related regulations. Ordinarily, a passive activity is an 16 activity involving the conduct of a trade or business 17 18 19 in which the taxpayer does not materially participate. Sec. 469(c) (1). However, except as provided in section 469(c) (7), the term "passive 20 activity" also includes a rental activity regardless 21 of whether a taxpayer materially participates in the 22 activity. Sec. 469(c) (2), (4). There are two 23 24 25 principal exceptions to the general rule that rental activities are per se passive activities. First, under section 469(c) (7), the rental activities of a 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 13 1 2 3 4 5 6 7 8 9 10 11 taxpayer who is a real estate professional are not treated as per se passive activities but rather as trade or business activities, subject to the material participation requirements of section 469(c) (1). See sec. 1.469-9(e) (1), Income Tax Regs. Second, under section 469(i), a taxpayer who "actively" participates in a rental real estate activity may deduct a maximum loss of $25,000 per year related to the activity. See sec. 469(i) (1) and (2). This second exception is subject to phaseout when the taxpayer's adjusted gross income (AGI) (determined 12 without regard to any passive activity loss) exceeds 13 14 15 16 17 18 19 20 21 $100,000. Sec. 469(i) (3). Under section 469(c) (7) (B) a taxpayer qualifies as a real estate professional, and the rental real estate activity of the taxpayer is not a per se passive activity under section 469(c) (2), if: (1) more than one-half 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 taxpayer 22 materially participates; and (2) the taxpayer 23 24 25 performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. Sec. 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 14 469(.c) (7) (B) (i) and (ii). In the case of a joint return the requirements of s·ection 469(c) (7) (B) are satisfied if and only if either spouse separately satisfies the requirements. Sec. 469(c) (7) (B). With respect to the evidence that may be used to establish a taxpayer's participation, section 1.469-5T(f) (4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), provides that The extent of an individual's participation in an activity may be established by any reasonable means. * * * Reasonable means * * * may include * * * 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. This Court has previously noted that while the regulations are somewhat ambiguous concerning the records to be maintained by taxpayers, we are not required to accept a postevent "ballpark guesstimate" or the unverified, undocumented testimony of taxpayers. See Moss v. Commissioner, 135 T.C. 365, 369 (2010); Hoskins v. Commissioner, T.C. Memo. 2013- 36; Estate of Stangeland v. Commissioner, T.C. Memo. 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 15 1 2 3 4 5 6 7 8 9 2010-185. Mr. Kennedy maintained no calendar, logbook, or other records to establish the extent of his participation in his purported real estate business. He was employed full time at Sullivan Pontiac and received a substantial salary for what we assume to be extensive services. Although Mr. Kennedy contends that he made many of the improvements to the Windermere property himself by 10 working nights and weekends, he testified that he 11 12 13 14 15 16 17 18 19 20 21 22 23 devoted more time to his full-time job than to his purported real estate activity. Because we are not persuaded that Mr. Kennedy spent more time on any real estate activity than he spent working for Sullivan Pontiac, he has not established that he is a real estate professional. Thus, we need not analyze whether he performed more than 750 hours of services during the taxable years in the purported real estate activity. His purported rental activity, therefore, 1s per se passive. Accordingly, petitioners are not entitled to any deduction for home mortgage interest in excess of the amount allowed by respondent. 24 Additional Income 25 Mr. and Mrs. Kennedy did not contest in 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 16 their petition or at trial that they received the $1,000 of additional income as determined by respondent for 2007. On their Form 1040X they specifically admitted that they received additional income of $1,000. Accordingly, we sustain respondent's determination with respect to the $1,000 of additional income for 2007. Section 6662(a) Penalty The Commissioner has the initial burden of producing evidence to support the applicability of a section 6662(a) penalty. Sec. 7491(c). To meet this burden, the Commissioner must come forward with sufficient evidence to show that it is appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). If the Commissioner satisfies this burden of production, the burden of producing evidence shifts to the taxpayer, who must demonstrate by a preponderance of the evidence that he or she is not liable for the penalty either because the penalty does not apply or because the taxpayer qualifies for relief Section 6662 (a) and (b) (1) and (2) authorizes the Commissioner to impose a penalty on an underpayment of tax that is attributable to 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 17 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 negligence or disregard of rules or regulations or any substantial understatement of income tax. An 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). An understatement is substantial in the case of an individual if the amount of the understatement for the taxable year exceeds the greater of 10% of the tax required to be shown on the return or $5,000. Sec. 6662(d) (1) (A). Respondent satisfied the initial burden of proof by showing that petitioners substantially understated their income tax liabilities for 2006 and 2007. Because respondent met the burden of production, petitioners must come forward with sufficient evidence to persuade the Court that respondent's determination is incorrect. Petitioners do not contend that there were no substantial understatements of income tax for the years in issue or that they satisfied the adequate disclosure and substantial authority provisions of section 6662. See sec. 6662 (d) (2) (B). However, petitioners do contend that they relied on their accountant, Anthony Barone, to determine what they 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 18 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 could report on their 2006 and 2007 returns. Mr. Barone testified that he prepared the returns, that he was aware of the interest limitations, and that he concluded the mortgage interest claimed on the returns was deductible. There appears to be no dispute that Mr. Barone had accurate information about the amount of mortgage interest paid. A taxpayer may establish reasonable cause and good faith within the meaning of section 6664 (c) if the taxpayer demonstrates that he or she reasonably relied in good faith on the informed advice of an independent professional adviser as to the proper tax treatment of an item. Sec. 1.6664- 4 (c), Income Tax Regs.; see also Neonatology Assocs. v. Commissioner, 115 T.C. 43, 98 (2000), aff'd, 299 F.3d 221 (3d Cir. 200.2). The taxpayer must show that: (1) the adviser was a competent and qualified professional who had sufficient expertise to justify the taxpayer's reliance; (2) the taxpayer provided 20 all necessary and accurate information to the 21 22 23 adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment in deciding on the proper tax treatment of the item. See 24 Neonatology Assocs. v. Commissioner, 115 T.C. at 99. 25 Mr. Barone has extensive experience in tax 866.488.DEPO www.CapitalReportingCompany.com Capital Reporting Company 1 return preparation. Mr. and Mrs. Kennedy relied on 2 Mr. Barone's judgment in deducting the amounts of 19 home mortgage interest they paid during the years in issue. We find that Mr. and Mrs. Kennedy were justified in relying on Mr. Barone. Accordingly, we sustain respondent's determination with respect to the deficiencies but we do not sustain the section 6662 penalties. To reflect the foregoing, decision will be entered for respondent with respect to the deficiencies and for petitioners with respect to the 'section 6662 accuracy-related penalties. THIS CONCLUDES THE COURT'S ORAL FINDINGS OF FACT AND OPINION IN THIS CASE. (Whereupon, at 12:03 p.m., the above- entitled matter was concluded.) 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