Decision will be entered for respondent as to the deficiencies and for petitioners as to the
LEYDEN,
In a notice of deficiency dated December 16, 2015, respondent determined deficiencies in petitioners' Federal income tax of $9,752 and $16,475 for 2011 and 2012, respectively. Respondent also determined accuracy-related penalties under
The issues for decision are whether petitioners2 are: (1) entitled to deduct rental real estate losses for 2011 and 2012 and (2) liable for accuracy-related penalties under
Petitioners' rental real estate loss deductions for 2011 and 2012 are limited by the passive activity loss rules in
Some of the facts are stipulated and are so2017 Tax Ct. Summary LEXIS 65">*66 found. The stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioners resided in California when they timely filed their petition.
During 2011 and 2012 Mr. Hickam brokered real estate mortgages and other loans as an independent contractor for a mortgage brokerage company where he was a branch manager. During 2012 Mr. Hickam was also paid wages by an employer for originating loans.3 In both positions Mr. Hickam's brokered or originated loans were secured by real estate. For 2011 and 2012 Mr. Hickam was a licensed real estate agent, but the record does not show whether he worked as a real estate agent during those years.
During 2011 and 2012 Mr. Hickam brokered and originated mortgage loans for clients to buy real estate; refinance existing loans; and secure reverse mortgages, commercial loans, and, occasionally, construction loans. Mr. Hickam did not operate, develop, redevelop, construct, reconstruct, or rent real estate in brokering mortgages or originating loans.4
When he brokered mortgages and originated loans, Mr. Hickam followed a structured work routine which2017 Tax Ct. Summary LEXIS 65">*67 he referred to as the "Core Coaching System". Under this system he engaged in certain activities on a given day. On Mondays he followed up with realtors as to whether they had had any open houses and client referrals during the preceding weekend. On Tuesdays he called realtors to get file status updates. On Wednesdays he updated clients. On Thursdays he engaged in "referral partner interactions". On Fridays he followed up with realtors to ask whether they needed any materials for their upcoming open houses.
Mr. Hickam's duties also included overseeing one to three other independent contractors and working with processors or assistants on his client files. Occasionally, he would meet with an appraiser or inspect the condition of a property that was to secure a loan.
The company for which Mr. Hickam worked as a branch manager provided him with an office. Mr. Hickam's work hours were flexible, and he was not always required to perform his work at the office.
During 2011 and 2012 Mr. Hickam did not record the amount of time he spent brokering mortgages and originating loans.
In addition to brokering mortgages and originating loans, Mr. Hickam2017 Tax Ct. Summary LEXIS 65">*68 managed and maintained the following three rental real estate properties (three properties):
| 1285 Norval Way | San Jose | Cal. |
| 4625 Topaz St. | Capitola | Cal. |
| 918 Del Mar Ave. | San Jose | Cal. |
The properties at 1285 Norval Way (Norval property) and 4625 Topaz Street (Topaz property) were single-family homes, and the property at 918 Del Mar Avenue (Del Mar property) was a nine-unit apartment building. In 2011 and 2012 Mr. Hickam lived approximately two miles from the Norval and Topaz properties. The record does not show who owned the Norval property or the Topaz property during the years at issue.
Mr. Hickam equally owned the Del Mar property with his brother and his parents. However, his brother and his parents did not participate in the management or maintenance of the Del Mar property because they did not reside in the area. Instead, they paid Mr. Hickam $6,000 per year to look after the property. He reported that amount as "other income" on petitioners' joint Federal income tax returns for 2011 and 2012.
During 2011 Mr. Hickam placed ads to lease the three properties and reviewed lease applications. He met with prospective tenants, obtained their credit reports, called their references2017 Tax Ct. Summary LEXIS 65">*69 and prior landlords, and prepared their leases. After a tenant vacated a property or a unit, Mr. Hickam inspected the property or unit for damage.
Mr. Hickam also periodically inspected the conditions of the three properties during the terms of the leases to see whether the properties had any damage or needed any repairs, spoke with the tenants and the gardeners, and ensured that garbage cans were returned to their appropriate locations after the garbage was collected.
If a property or a unit sustained minor damage, Mr. Hickam would purchase the materials and perform the required repairs. If the property sustained major damage, Mr. Hickam would seek bids, meet with contractors, and oversee the repairs.
Most of the units in the Del Mar property were remodeled during 2011 and 2012. Mr. Hickam took advantage of a unit's turnover to complete its remodeling. Four units and five units turned over in 2011 and 2012, respectively.
Mr. Hickam did not keep contemporaneous records of the hours he spent or the services he performed with respect to the three properties. When the Internal Revenue Service (IRS) audited petitioners' 2011 and 2012 tax returns, and in response to the audit, Mr. Hickam prepared2017 Tax Ct. Summary LEXIS 65">*70 a log of his hours and his services with respect to the three properties.
Sometime after 2011 Mr. Hickam prepared a document titled "Non Contemporaneous Recreation [sic] of Time" (2011 log) with handwritten entries. The 2011 log grouped services with respect to the three properties into five categories: "Del Mar, Norval, Topaz, P.O. Box, and Bills/Paperwork/Bids/Apps". Mr. Hickam wrote the number of hours he estimated he had spent for each category on a particular day of the month. For instance, for Saturday, January 8, 2011, Mr. Hickam wrote that he spent one hour with respect to "Del Mar", one hour with respect to "Norval Way", and two hours with respect to "Bills/Paperwork/Bids/Apps". The 2011 log does not explain the particular services performed in any of the five categories.
The 2011 log also grouped Mr. Hickam's mortgage brokerage services and his loan origination services into six categories: "Pipeline Review, Marketing/Promo, Client Interface, Office/Bills/Documentation, Training/Licensing, and Referral Partners/Phase". As with the entries with respect to the three properties, Mr. Hickam wrote the number of hours he estimated he had spent for each category for a particular day2017 Tax Ct. Summary LEXIS 65">*71 of the month. These entries also do not explain the particular services performed in any of the six categories.
Sometime after 2012 Mr. Hickam prepared a noncontemporaneous calendar for each month (collectively, 2012 calendars). The 2012 calendars contained entries in one-hour increments followed by one word or a two-word phrase. The entries referred to the three properties or Mr. Hickam's mortgage brokerage services and his loan origination services. However, none of the phrases explains the services Mr. Hickam performed.
Petitioners timely filed their 2011 and 2012 tax returns, reporting gross income of $170,644 and $266,447 for 2011 and 2012, respectively. Mr. Hickam included in each year's reported gross income the $6,000 his brother and his parents had paid him in that year for managing the Del Mar property.
Each included a Schedule E, Supplemental Income and Loss, reporting gross rental income and expenses for the three properties. In those Schedules E petitioners reported net losses for the Norval and Topaz properties and net profits for the Del Mar property. Petitioners did not report any other income from other rental real estate services2017 Tax Ct. Summary LEXIS 65">*72 or other property management services for 2011 or 2012. In their Schedules E petitioners claimed rental real estate loss deductions of $47,730 and $48,945 for 2011 and 2012, respectively, for the three properties.5 Petitioners attached to their 2011 tax return an election to treat the three properties as one activity.
Generally, the Commissioner's determination of a deficiency is presumed correct, and the taxpayer bears the burden of proving it incorrect.
Generally, a passive activity is any trade or business in which the taxpayer does not materially participate.
Whether the disallowed rental real estate loss deductions petitioners claimed for 2011 and 20122017 Tax Ct. Summary LEXIS 65">*74 are deductible without limitation under the passive activity loss rules depends on whether Mr. Hickam8 met the definition of a real estate professional under
The Court holds that neither Mr. Hickam's mortgage brokerage services nor his loan origination services are performed in a real property trade or business within the meaning of
Mr. Hickam argues that the Court should treat his mortgage brokerage services and his loan origination services as performed in real property trades or businesses and any hours he spent performing those services should be included for purposes of satisfying the real estate professional test. The Court disagrees.
(C) Real property trade or business.--For purposes of this paragraph, the term "real property trade or business" means any
Mr. Hickam focuses on the word "operation" and argues that his mortgage brokerage services and his loan origination services are performed in trades or businesses in real property operation because the underlying assets in both services are real property. Mr. Hickam also argues that respondent erred in retroactively applying an IRS Chief Counsel Advice (CCA) issued in 2014 to disallow petitioners' 2011 and 2012 rental real estate loss deductions.
Respondent contends that the statute is clear that mortgage brokerage and loan origination services are not real property trades or businesses. Respondent further contends that the CCA, rather than establishing2017 Tax Ct. Summary LEXIS 65">*76 a new interpretation of the law, correctly relied upon the statute.
Mr. Hickam's mortgage brokerage services and his loan origination services relate to brokering and originating residential and commercial loans and not to the operation or brokerage of real property. The Court holds that neither Mr. Hickam's mortgage brokerage services and his loan origination services constitute real property trades or businesses for purposes of
Mr. Hickam's argument that his mortgage brokerage services and his loan origination services are performed in trades or businesses in "real property operation" because the underlying assets are real property is too attenuated. His argument ignores the words "real property" that precede the specific activities listed in the statute; those words modify each of those activities, including "operation". Although the loans he brokered and originated were secured by real property, Mr. Hickam's mortgage brokerage services and his loan origination services did not involve operating the real properties that secured those loans.
Further, while Mr. Hickam's2017 Tax Ct. Summary LEXIS 65">*77 mortgage brokerage services constitute a "brokerage" trade or business, they does not constitute a "real property brokerage" trade or business. Mr. Hickam did not broker real estate during either year at issue. Rather, he brokered loans between buyers and financial institutions.
The legislative history of the statute supports the consequence of this distinction. Congress considered including "finance operations" in the activities listed in
Mr. Hickam relies on
The parties in that case agreed that during the tax year at issue the taxpayer was a real estate professional under
Mr. Hickam neither operated real property nor brokered real property as part of his mortgage brokerage services and his loan origination services. Accordingly, the Court holds that neither service constitutes a real property trade or business.
To qualify as a real2017 Tax Ct. Summary LEXIS 65">*79 estate professional a taxpayer must own at least one interest in rental real estate and meet both tests under
On the basis of the record the Court determines that Mr. Hickam's rental real estate activity with respect to the three properties constituted a real property trade or business for 2011 and 2012.
To satisfy the first test under
A taxpayer may use any reasonable means to establish his hours of participation.
Using the 2011 log and the 2012 calendars, Mr. Hickam testified that he had performed 1,583 and 1,200 hours of services in 2011 and 2012, respectively, with respect to his mortgage brokerage services and his loan origination services and 836 and 759 hours of services in 2011 and 2012, respectively, with respect to the three properties. Mr. Hickam began reconstructing the hours of services he performed with respect to the mortgage brokerage services and the loan origination services and the three properties after his 2011 and 2012 tax returns were audited. He prepared the 2011 log and the 2012 calendars in response to the audit. Mr. Hickam testified that he had created the 2011 log and the 2012 calendars using leases, bank statements, checkbooks, bills, and receipts to reconstruct the amount of time he spent leasing, operating, and maintaining the three properties, but he did not present any of this corroborating evidence at trial. Mr. Hickam also testified2017 Tax Ct. Summary LEXIS 65">*82 that his accountant had suggested he estimate the amount of time for each activity performed to prepare the 2011 log and the 2012 calendars.
According to respondent the 2011 log and the 2012 calendars are not reliable and therefore do not establish the amount of time Mr. Hickam dedicated to his mortgage brokerage services and his loan origination services or the three properties. The Court agrees with respondent and does not find the 2011 log or the 2012 calendars to be reliable. They were prepared well after the years at issue with vague, nondescriptive entries and ballpark estimates of the time dedicated to the three properties.
Petitioners did not provide any other credible evidence10 to support Mr. Hickam's testimony that he had performed 1,583 hours and 1,200 hours of services in 2011 and 2012, respectively, with respect to his mortgage brokerage services and his loan origination services and 836 and 789 hours of services in 2011 and 2012, respectively, with respect to the three properties.
A taxpayer's uncorroborated testimony need not be relied upon.
While2017 Tax Ct. Summary LEXIS 65">*83 the Court believes that Mr. Hickam dedicated time to his mortgage brokerage services, his loan origination services, and the three properties during the years at issue, he did not persuade the Court that the amount of time he listed on the 2011 log and the 2012 calendars accurately represented his hours of services for 2011 or 2012.
Petitioners have failed to sustain their burden of proving that Mr. Hickam was a real estate professional for 2011 or 2012. Accordingly, petitioners may not deduct the rental real estate losses claimed on their 2011 or 2012 tax return under the real estate professional exception provided under
Respondent determined accuracy-related penalties for 2011 and 2012 because petitioners' underpayments were due to substantial understatements of income tax or negligence or disregard of rules and regulations.
Under
Once the Commissioner meets his burden of production, a taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect.
The Court has sustained2017 Tax Ct. Summary LEXIS 65">*85 the disallowed deductions in the notice of deficiency for 2011 and 2012. The result is a substantial understatement of income tax for 2011 and 2012. An "understatement" means the excess of the amount of the tax required to be shown on the tax return over the amount of tax that is shown on the tax return, reduced by any rebate.
Petitioners' 2011 tax return showed a tax of $18,358. Respondent determined the amount of tax required to be shown on petitioners' 2011 tax return was $28,110. Thus, the understatement of tax that respondent determined for 2011 was $9,752. That amount exceeds $5,000, which is greater than $2,811.80, 10% of the tax required to be shown on petitioners' 2011 tax return.
Petitioners' 2012 tax return showed a tax of $39,244. Respondent determined the amount of tax required to be shown on petitioners' tax return was $55,719. Thus, the understatement of tax that respondent determined for 2011 was $16,475. That amount exceeds $5,571.90,2017 Tax Ct. Summary LEXIS 65">*86 10% of the tax required to be shown on petitioners' 2012 tax return, which is greater than $5,000.
Therefore, petitioners have substantially understated their income tax for 2011 and 2012 and are liable for the accuracy-related penalties under
The accuracy-related penalty may also be imposed under
Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code and any failure to keep adequate books and records or to substantiate items properly.
Respondent has met his burden of production with respect to2017 Tax Ct. Summary LEXIS 65">*87 petitioners' negligence and disregard of rules or regulations because Mr. Hickam failed to maintain adequate records to substantiate the rental real estate loss item underlying the deduction for 2011 or 2012.
A penalty will not be imposed under
Petitioners argued that they relied in good faith on their accountant's recommendation and that this reliance was reasonable cause for their underpayment of tax for 2011 and 2012. The question of whether Mr. Hickam was a real estate professional was partially resolved on technical grounds--whether his mortgage brokerage services and loan origination services constituted real property trades or businesses under
The Court has considered all of the parties' arguments, and, to the extent not addressed herein, the Court concludes they are moot, irrelevant, or without merit.
To reflect the foregoing,
1. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the relevant years, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. Michelle Hickam did not appear in Court at trial, but the Court's decision will be binding upon both spouses.↩
3. Mr. Hickam did not explain why he was paid as an independent contractor for his role as a branch manager in 2011 and 2012 and as an employee of his employer in 2012.↩
4. On a handful of occasions over the years Mr. Hickam advised former clients for whom he had brokered a mortgage on how to lease property and reviewed their leases.↩
5. In the Schedules E petitioners reported nonpassive income, unrelated to a rental real estate activity, from "KM Hickam Partnership" totaling $126,270 and $71,065 for 2011 and 2012, respectively. Petitioners subtracted the reported net rental real estate losses for the three properties for 2011 and 2012 from the reported partnership income. The resulting net total income of $78,540 and $22,120 for 2011 and 2012, respectively, was reported on line 17 of petitioners' 2011 and 2012 tax returns. Petitioners each filed SchedulesSE, Self-Employment Tax, for 2011 and 2012, calculating the self-employment tax on their respective portions of the partnership income. Mr. Hickam did not testify about the work he or Mrs. Hickam had performed for the partnership.↩
6. The effect of the passive activity loss disallowance rule is that deductions related to passive activities are allowed against income from passive activities and the excess (i.e., the amount by which the deductions related to the passive activities exceed the income from passive activities) cannot be deducted from income from activities other than passive activities.
7. There is an additional exception under
8. In the case of a joint Federal income tax return, the requirements are met if either spouse separately satisfies the requirements.
9. In applying the two tests the taxpayer may elect to treat all interests in rental real estate as one activity.
10. Even though the parties stipulated leases for the units in the Del Mar property, the leases did not provide any indication of the amount of time Mr. Hickam devoted to the respective units listed for the property.↩
