T.C. Memo. 2018-28



                  UNITED STATES TAX COURT



     DAVID KEEFE AND CANDACE KEEFE, Petitioners v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 15189-14, 29804-15.              Filed March 15, 2018.



Richard Michael Gabor, for petitioners.

Eliezer Klein and Peter N. Scharff, for respondent.
                                        -2-

[*2]         MEMORANDUM FINDINGS OF FACT AND OPINION


       MARVEL, Chief Judge: Respondent determined the following deficiencies

in Federal income tax, accuracy-related penalties under section 6662(a),1 and

additions to tax under section 6651(a)(1) with respect to petitioners’ joint Federal

income tax returns:

                                              Penalty          Addition to tax
           Year          Deficiency         sec. 6662(a)       sec. 6651(a)(1)
           2004            $78,292            $15,658                 --
           2005            144,053             28,811                 --
           2006            218,228             43,646               $408
           2007            143,729             28,161                675
           2008            141,870             12,817             35,468
           2009            252,777             50,555                 --
           2010            309,060             61,812                 --

       After concessions, the issues for decision are: (1) whether petitioners held

Wrentham House Mansion as real property used in a trade or business or as a

capital asset; (2) whether certain interest payments petitioners made are properly



       1
        Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Some monetary amounts are rounded
to the nearest dollar.
                                          -3-

[*3] included in their adjusted basis in the property at the time of sale; (3) whether

petitioners are liable for additions to tax under section 6651(a)(1) for their failure

to timely file their joint Federal income tax returns for tax years 2006, 2007, and

2008; and (4) whether petitioners are liable for accuracy-related penalties under

section 6662(a) for tax years 2004 through 2010.

                                FINDINGS OF FACT

      Some of the facts have been stipulated and are so found. The stipulated

facts and facts drawn from stipulated exhibits are incorporated herein by this

reference. Petitioners resided in New York when they petitioned this Court.

I.    Petitioners

      Petitioners are married and have seven children. Petitioner Candace Keefe

has a bachelor’s degree in art history and graduate degrees in education and

journalism. Petitioner David Keefe is a fertility doctor who was employed full

time during all years at issue in this case.

      In 1996 Dr. Keefe was appointed Director of the Division of Reproductive

Endocrinology at Brown University and Women and Infants Hospital in

Providence, Rhode Island. Dr. Keefe and his family moved to Newport, Rhode

Island, that same year. Neither petitioner is or was ever a licensed architect or

contractor.
                                        -4-

[*4] In May 2000 petitioners rented Bois Doré, a 20,000-square-foot residence in

Newport, Rhode Island, and on August 23, 2004, they purchased it. Bois Doré is

near downtown Newport, the beach, and the library but does not have a view of

the Atlantic Ocean. Petitioners and their children resided at Bois Doré from May

2000 until they moved to Tampa, Florida, in September 2005. Petitioners lived in

Tampa, Florida, from September 2005 until they moved to New York, New York,

in October 2009, where they resided as of the date of the trial.

II.   Real Estate Purchase

      On January 21, 2000, petitioners purchased a historic waterfront mansion

and grounds on Ocean Avenue in Newport, Rhode Island (Ocean Avenue

property), for $1.35 million, intending to restore it. The Ocean Avenue property

was designed by Richard Morris Hunt, the founder of the American Institute of

Architects, and the grounds were designed by Frederick Law Olmstead, a well-

known landscape designer. The Ocean Avenue property is at the highest point on

Ocean Avenue, and each room provides a view of the Atlantic Ocean.

      The Ocean Avenue property was built in 1890 as a summer residence and

was used as such until the mid-1960s when it was purchased by a neighboring

property owner who abandoned it. After four decades of sitting vacant and
                                        -5-

[*5] exposed to weather and vandals, the Ocean Avenue property was

uninhabitable when petitioners purchased it.

       On October 30, 2002, petitioners executed a Declaration of Condominium

(declaration), dividing the Ocean Avenue property into two units, Unit 1

(Wrentham House Mansion), and Unit 2 (Carriage House) (collectively,

Wrentham House Condominium). Wrentham House Mansion constitutes 57% of

the Wrentham House Condominium, and the Carriage House constitutes the

remaining 43%. On November 1, 2002, petitioners executed a warranty deed in

which they conveyed Carriage House to Frank and Ashley O’Keefe. Petitioners

retained ownership of Wrentham House Mansion after the sale of Carriage House.

The O’Keefes paid petitioners $950,000 for Carriage House.

III.   Financing and Tax Credits

       Petitioners financed the purchase of the Ocean Avenue Property and the

restoration of Wrentham House Mansion through a series of loans. As restoration

costs increased, petitioners were forced to secure additional loans to continue the

renovations. Petitioners borrowed over $9 million at interest rates varying from

3.5% to 25% to renovate Wrentham House Mansion.

       Petitioners were aware of State tax credits and the Federal Historic

Preservation Investment Tax Credit (tax credits) that could have helped them
                                         -6-

[*6] recover some of the costs of purchasing and restoring Wrentham House

Mansion. These tax credits could be obtained only if certain conditions relating to

the restoration and use of the property were satisfied. Specifically, the State of

Rhode Island Historical Preservation & Heritage Commission (commission)

required historically accurate restoration of the building in order for its owners to

receive both credits, and for the Federal tax credit the commission also required

that the property be rented to tenants for at least five years. Petitioners intended to

qualify for and obtain the State and Federal tax credits. They did not intend to

reside in Wrentham House Mansion.

      In 2006 petitioners applied to the commission for the State tax credit, and in

2007 the commission determined that the restoration of Wrentham House Mansion

up to that point met the qualifications for the credit. Petitioners did not claim or

receive the Federal tax credit with respect to the Wrentham House Mansion

renovation.

IV.   Wrentham House Mansion Construction

      Before beginning the restoration, petitioners received cost estimates of

approximately $2 million for the restoration of Wrentham House Mansion from

several contractors. On the basis of an estimate submitted by M&M Marques

Construction Co., Inc., petitioners hired the company as the general contractor to
                                        -7-

[*7] restore Wrentham House Mansion. Restoration of Wrentham House Mansion

started at the end of 2002 and continued until 2008 with some unexpected delays

occurring along the way. For example, progress was delayed for several months in

2005 because of health problems of multiple subcontractors. Work was further

delayed when unforeseen structural problems with the building arose, adding time

and expense to the restoration.

      From the time the construction began in 2002 through 2004, Mrs. Keefe

went to Wrentham House Mansion regularly to oversee the progress of the

restoration. In 2005 after the family had moved to Tampa, Florida, Mrs. Keefe

flew to Newport frequently to oversee the construction. When Mrs. Keefe was not

in Newport, she closely managed the progress of the restoration via telephone

calls. On April 11, 2007, petitioners received a temporary certificate of use and

occupancy for Wrentham House Mansion. On October 31, 2007, petitioners

received a second temporary certificate of use and occupancy, and on June 11,

2008, they received a final certificate of use and occupancy. The restoration of

Wrentham House Mansion was completed at the end of May 2008.

V.    Attempted Rental of Wrentham House Mansion

      Many of America’s wealthiest families live or vacation in Newport, Rhode

Island, during the summer. Summer rentals in Newport generally begin around
                                          -8-

[*8] Memorial Day and end around Labor Day. Petitioners intended to offer

Wrentham House Mansion for rent once the restoration of the property was

complete in order to obtain the Federal income tax credits. Petitioners were

informed that Wrentham House Mansion could produce rental income of $75,000

per month during the summer and $10,000 per month for the remainder of the

year.2

         In 2006 petitioners met with Laurie Hewitt Burke, a rental agent for luxury

properties who was employed by Lila Delman Real Estate, to discuss renting

Wrentham House Mansion. Ms. Burke inspected Wrentham House Mansion, but

at that time it was not in a condition to be rented.

         In 2007 Ms. Burke again visited Wrentham House Mansion and met with

petitioners, but the property was still not ready to be rented. However, because

petitioners hoped that the property would be ready to rent by the summer of 2007,

Ms. Burke began speaking to her clients who were interested in luxury rentals in

Newport about the prospect of renting Wrentham House Mansion.




         2
       Section 6.2(2) of the declaration states that “[n]o [u]nit may be leased or
rented more than one time in each calendar year” and, therefore, restricts the
amount of rental income that Wrentham House Mansion could generate in a
calendar year.
                                       -9-

[*9] Ms. Burke did not post any pictures or other information about Wrentham

House Mansion on any website during 2007 because she did not believe she could

market it online while it was still being renovated. Ms. Burke continued to visit

Wrentham House Mansion throughout 2007 and early 2008. Wrentham House

Mansion was still being renovated in early 2008, but petitioners hoped that it

would be ready to rent for the 2008 summer season.

      Although Ms. Burke did not list Wrentham House Mansion for rent on her

website during 2007 or 2008, she communicated its availability orally to her

existing clients. In February 2008 one of Ms. Burke’s clients, who normally

rented property from Memorial Day to Labor Day, expressed an interest in renting

Wrentham House Mansion. However, because the renovations were still not

complete, no lessee executed a rental agreement or paid any rent to lease

Wrentham House Mansion.

      Petitioners did not register Wrentham House Mansion with the Newport,

Rhode Island, city clerk’s office as a “Short-Term Rental” or a “Guest House”.3

Neither did they comply with the requirements of the declaration in order to rent


      3
       According to the City of Newport, Rhode Island, city clerk, the term
“Short-Term Rentals” refers to non-owner-occupied homes with rentals of nine
months or less, and the term “Guest Houses” refers to bed and breakfast
operations.
                                       - 10 -

[*10] out Wrentham House Mansion.4 Petitioners never secured a tenant for

Wrentham House Mansion and did not rent it before its sale.

VI.   Sale Activities

      Bank of America, one of petitioners’ lenders, required petitioners to offer

Wrentham House Mansion for sale during the construction process in order for

petitioners to carry two mortgages on the property. Petitioners contracted with

Lila Delman Real Estate from May 7, 2004, through August 31, 2008, and from

September 8, 2008, through July 31, 2009, to list Wrentham House Mansion for

sale. On or about June 22, 2005, petitioners received an appraisal report valuing

Wrentham House Mansion at $12.5 million as of that date, subject to completion

of the restoration work. Wrentham House Mansion was later appraised by the

Assessor’s Office of Newport, Rhode Island, as of August 31, 2008, at

$10,667,800, and as of July 31, 2009, at $9,610,200.

      In 2008 around the time the prospective tenant decided not to rent

Wrentham House Mansion, Bank of America increased petitioners’ required

mortgage payment from $25,000 to $39,000 per month. Struggling to meet this


      4
       The declaration requires that all leases be recorded in writing; that all
leases of less than 12 months be approved by the executive board of the
condominium; and that written notice of any proposed lease be sent to the owners
of Carriage House at least 45 days before the proposed lease is to begin.
                                        - 11 -

[*11] financial burden, petitioners pursued other avenues to sell Wrentham House

Mansion. They contacted three auctioneers to arrange an auction, but for various

reasons an auction never took place. On July 31, 2009, petitioners sold Wrentham

House Mansion in a short sale for $6.51 million.

VII. Basis and Expenses

      The parties agree that $751,750 is the proper allocation of the purchase

price of the Ocean Avenue Property to petitioners’ cost basis. The parties also

agree that petitioners are entitled to increase their basis by $4.5 million, which

they paid for various capital expenses associated with the restoration of Wrentham

House Mansion. Petitioners also paid $3.3 million of interest on loans secured by

mortgages allocable to Wrentham House Mansion. Although the parties agree that

the purchase price and restoration expenses are properly capitalized into the basis

of Wrentham House Mansion, they disagree on whether interest paid on the loans

must be capitalized.

VIII. Tax Returns, Notices of Deficiency, and Pleading Documents

      Petitioners’ original Forms 1040, U.S. Individual Income Tax Return, for

tax years 2004 through 2009 were prepared by Arthur Yorkes & Co. Petitioners
                                         - 12 -

[*12] failed to timely file their 2006, 2007, and 2008 Federal income tax returns,5

and they failed to pay their Federal income tax liabilities for tax years 2004, 2005,

2006, and 2007. Respondent issued petitioners notices of intent to levy to collect

the unpaid tax liabilities for these years.

      Petitioners prepared a list of various expenditures they made in 2009 to

assist Arthur Yorkes & Co. in the preparation of their original 2009 Federal

income tax return. On their original 2009 return, petitioners reported that their

adjusted basis in Wrentham House Mansion was $8,560,923, and they treated the

sale of the property as the sale of a capital asset. After speaking with an estate

planner, petitioners decided that Wrentham House Mansion should have been

treated as a business property for Federal income tax purposes and that they were

entitled to an ordinary loss deduction on its sale. Petitioners subsequently hired

Gabor & Associates to prepare amended tax returns for 2004 through 2009 and

their original 2010 return.

      In their amended 2009 income tax return, petitioners reported that

Wrentham House Mansion was a business property and that their adjusted basis

was $10,045,000 on the date of sale. As a result of the change in the character of


      5
      Petitioners filed their Federal income tax returns for 2006, 2007, and 2008
on April 14, 2010.
                                        - 13 -

[*13] and their adjusted basis in Wrentham House Mansion, petitioners reported a

net operating loss (NOL), which they carried back to 2004 and then forward to

2010 using amended returns to eliminate existing tax liabilities. Petitioners’

amended returns were received and processed by respondent.6

      On May 14, 2014, respondent mailed to petitioners, by certified mail, a

notice of deficiency for tax years 2008, 2009, and 2010 determining tax

deficiencies, penalties, and additions to tax. On August 27, 2015, respondent

mailed to petitioners, by certified mail, a notice of deficiency for tax years 2004,

2005, 2006, and 2007 determining tax deficiencies, penalties, and additions to tax.

Petitioners timely filed a petition for redetermination with this Court with respect

to the notices of deficiency. Respondent did not determine an addition to tax

under section 6651(a)(1) in the notice of deficiency for 2008, but did assert one in

an amended answer. As to all section 6662 penalties, respondent’s employee

secured supervisory approval as required by section 6751(b)(1).




      6
        Petitioners did not claim depreciation expenses on Wrentham House
Mansion or deduct any expenses attributable to Wrentham House Mansion for any
of the taxable years at issue.
                                        - 14 -

[*14]                                OPINION

I.      Burden of Proof

        Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and the taxpayer bears the burden of proving that those

determinations are erroneous. See Rule 142(a); Welch v. Helvering, 

,

115 (1933). Moreover, tax deductions are a matter of legislative grace, and the

taxpayer has the burden of proving entitlement to the deductions claimed. Rule

142(a); INDOPCO, Inc. v. Commissioner, 

, 84 (1992); New Colonial

Ice Co. v. Helvering, 

, 440 (1934). However, if a taxpayer produces

credible evidence7 with respect to any relevant factual issue and meets other

requirements imposed by section 7491(a)(2),8 the burden of proof on any such

issue shifts to the Commissioner. Sec. 7491(a)(1). Petitioners do not argue for a




        7
       “Credible evidence is the quality of evidence which, after critical analysis,
the court would find sufficient upon which to base a decision on the issue if no
contrary evidence were submitted (without regard to the judicial presumption of
IRS correctness).” Higbee v. Commissioner, 

, 442 (2001) (quoting
H.R. Conf. Rept. No. 105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-995).
        8
       Sec. 7491(a)(2) requires a taxpayer to demonstrate that he or she
(1) complied with the requirements under the Code to substantiate any item,
(2) maintained all records required under the Code, and (3) cooperated with
reasonable requests by the Secretary for witnesses, information, documents,
meetings, and interviews. See Higbee v. Commissioner, 116 T.C. at 440-441.
                                        - 15 -

[*15] shift in the burden of proof, and they have not proven that they have met the

section 7491(a)(2) requirements.

II.   The Character of Wrentham House Mansion in the Hands of Petitioners

      We first address whether petitioners held Wrentham House Mansion as real

property used in a trade or business or as a capital asset.

      A capital asset is property held by a taxpayer (whether or not connected

with a trade or business), but that does not include property used in a taxpayer’s

trade or business for which depreciation is permitted under section 167,9 or real

property used in the taxpayer’s trade or business. Sec. 1221(a)(2). Property held

for the production of income, but not used in a trade or business of the taxpayer, is

a capital asset subject to the limitations on losses under section 1211(b). Sec.

1.1221-1(b), Income Tax Regs.

      The Court of Appeals for the Second Circuit10 requires that taxpayers be

engaged in continuous, regular, and substantial activity in relation to the


      9
       Sec. 167 allows a depreciation deduction for the exhaustion, wear and tear,
and obsolescence of property used in a taxpayer’s trade or business or property
held for the production of income.
      10
        This Court will “follow a Court of Appeals decision which is squarely in
point where appeal from our decision lies to that Court of Appeals and to that
court alone.” Golsen v. Commissioner, 

, 757 (1970), aff’d, 

 (10th Cir. 1971). This case is appealable to the U.S. Court of Appeals for the
Second Circuit, absent a stipulation to the contrary. See sec. 7482(b)(1)(A), (2).
                                        - 16 -

[*16] management of the property to support a conclusion that the property was

used in a trade or business and was not a capital asset. See, e.g., Gilford v.

Commissioner, 

, 736 (2d Cir. 1953) (the performance of sufficient

rental-related activity, either by the taxpayer or an agent of the taxpayer, will

support the conclusion that the taxpayer was engaged in a trade or business with

respect to the property); Union Natl. Bank of Troy v. United States, 

, 384 (N.D.N.Y. 1961) (stating that Grier is “settled law” in the Second

Circuit); Grier v. United States, 

 (D. Conn. 1954), aff’d per

curiam, 

 (2d Cir. 1955).

      Petitioners contend that they held Wrentham House Mansion as an asset

used in a rental real estate business. In deciding whether a rental property is used

in a trade or business or is a capital asset, the Court of Appeals for the Second

Circuit has examined the taxpayer’s rental-related activities for continuity,

regularity, and substance. Among the facts considered are the taxpayer’s efforts to

rent the property; the maintenance and repairs supplied by the taxpayer or an agent

of the taxpayer; the taxpayer’s employment of labor to manage the property or

provide services to tenants; the purchase of materials; the collection of rent; and

the payment of expenses. See Alvary v. United States, 

, 796-797 (2d

Cir. 1962); Gilford v. Commissioner, 201 F.2d at 736; Pinchot v. Commissioner,
                                        - 17 -

[*17] 

, 719 (2d Cir. 1940); Balsamo v. Commissioner, T.C. Memo.

1987-477; Grier, 120 F. Supp. at 398. The totality of the facts and circumstances

surrounding the use of the property must support a conclusion that the alleged

rental activities were sufficient, continuous, and substantial enough to constitute a

trade or business with respect to the rental of the property.

      While we have no doubt that petitioners devoted a great deal of time, effort,

and expense to the renovation of Wrentham House Mansion, the record

overwhelmingly confirms that Wrentham House Mansion was never held out for

rent or rented after the restoration was complete. Quite simply, the rental activity

with respect to Wrentham House Mansion never commenced in any meaningful or

substantive way. The cases on which petitioners rely are distinguishable because

in each case where a rental trade or business was found to exist, the taxpayer had

already started the rental activity and had provided substantial and continuous

rental-related services. See Alvary, 302 F.2d at 796; Gilford v. Commissioner,

201 F.2d at 736; Pinchot v. Commissioner, 113 F.2d at 719. In contrast,

petitioners never started a rental trade or business involving Wrentham House

Mansion. Richmond Television Corp. v. United States, 

, 907 (4th

Cir. 1965), vacated and remanded on other grounds, 

 (1965); Glotov v.

Commissioner, T.C. Memo. 2007-147, slip op. at 5 (holding that a taxpayer is not
                                        - 18 -

[*18] carrying on a trade or business until the business is functioning as a going

concern and performing the activities for which it was organized).

       Because petitioners did not commence or operate a rental activity with

respect to Wrentham House Mansion during the years at issue, we hold that

Wrentham House Mansion was a capital asset at the time of its sale. It follows

that any gain or loss was derived from the sale of a capital asset and respondent

properly disallowed the NOL carryovers.

III.   Interest Expenses

       The parties agree that petitioners’ basis in Wrentham House Mansion

includes the portion of the original purchase price allocable to Wrentham House

Mansion after the transfer of Carriage House, as well as the costs associated with

the restoration work. The parties disagree as to whether petitioners are required to

capitalize interest on loans taken out for the acquisition and restoration of

Wrentham House Mansion.

       Certain direct and indirect costs associated with producing property,

including property held for investment, must be capitalized into the basis of that

property. Sec. 263A(a), (b)(2)(A), (c)(1). Interest expenses are capitalized to the

extent that they are paid or incurred during the period in which the property is

being constructed or produced, and are allocable to real property. Id. subsec.
                                       - 19 -

[*19] (f)(1)(A) and (B)(i). Improvements to property, including the rehabilitation

or preservation of a standing building, constitute the production of property for

purposes of section 263A. Sec. 1.263A-8(d)(3)(i) and (ii), Income Tax Regs. The

production period begins on the date on which the physical production activity is

first performed and ordinarily ends on the date that the property is ready to be

placed in service or held for sale. Sec. 263A(f)(4)(B); sec. 1.263A-12(c)(2),

(d)(1), Income Tax Regs. The production period, however, does not end for a unit

of property before the completion of physical production activities by the taxpayer

even though the property is held for sale or lease. Sec. 1.263A-12(d)(2), Income

Tax Regs.

      Wrentham House Mansion is a capital asset in the hands of petitioners and

is subject to the uniform capitalization rules under section 263A. Their extensive

restoration work is the type of improvement for which interest is appropriately

capitalized under section 263A. The production period began on the date the

physical restoration work began and ended on the date when it was completely

finished. The date of completion of the physical construction work is the date

when the renovation of Wrentham House Mansion was completed and the

property was ready to be placed in service or held for sale. See sec. 1.263A-
                                         - 20 -

[*20] 12(d)(2), Income Tax Regs. Accordingly, we hold that interest expenses

paid or incurred during the production period must be capitalized.

IV.   Additions to Tax and Penalties

      The Commissioner has the initial burden of production with respect to

additions to tax and penalties and must produce sufficient evidence indicating that

it is appropriate to impose an addition to tax or a penalty. Sec. 7491(c); Higbee v.

Commissioner, 

, 446-447 (2001). Once the Commissioner satisfies

his burden of production, the taxpayer may introduce evidence that the imposition

of the penalty is not justified. See Rule 142(a); Welch v. Helvering, 290 U.S. at

115; Higbee v. Commissioner, 116 T.C. at 447.

      A.     Section 6651(a)(1) Additions to Tax for Failure To Timely File

      In the notice of deficiency respondent determined that petitioners were

liable for additions to tax for failure to timely file returns for tax years 2006 and

2007. In respondent’s amended answer, respondent also asserted additions to tax

for failure to timely file for tax year 2008. Section 6651(a)(1) imposes an addition

to tax for failure to file a timely Federal income tax return unless the taxpayer can

demonstrate that such failure was due to reasonable cause and not due to willful

neglect. See United States v. Boyle, 

, 245 (1985).
                                        - 21 -

[*21] Respondent has met his burden of production and proof supporting the

imposition of these additions to tax. We find that petitioners failed to timely file

their Federal income tax returns for tax years 2006 through 2008. Petitioners have

made no argument and produced no evidence with respect to the additions to tax.

Accordingly, we sustain respondent’s determination as to the additions to tax.

      B.     Section 6662(a) Accuracy-Related Penalties

      Respondent determined that petitioners are liable for accuracy-related

penalties under section 6662(a) and (b)(1) and (2) for tax years 2004 through 2010

for underpayments due to substantial understatements of income tax or,

alternatively, to negligence or disregard of rules and regulations. A taxpayer may

be liable for a 20% accuracy-related penalty on the portion of an underpayment of

income tax attributable to a substantial understatement of income tax or to

negligence or disregard of rules or regulations. Sec. 6662(a)-(d). Only one

section 6662 accuracy-related penalty may be imposed with respect to any given

portion of an underpayment, even if that portion is attributable to more than one

type of conduct listed in section 6662(b). See New Phoenix Sunrise Corp. v.

Commissioner, 

, 187 (2009), aff’d, 408 F. App’x 908 (6th Cir. 2010);

sec. 1.6662-2(c), Income Tax Regs. Nevertheless, we consider both grounds for
                                          - 22 -

[*22] imposition of the penalty. The Commissioner bears the burden of

production with respect to a section 6662 penalty. Sec. 7491(c).

         Section 6751(b)(1) provides that, subject to certain exceptions in section

6751(b)(2), no penalty shall be assessed unless the initial determination of such

assessment is personally approved in writing by the immediate supervisor of the

individual making such determination or such higher level official as the Secretary

may designate. Written approval of the initial penalty determination under section

6751(b)(1) must be obtained no later than the date the notice of deficiency is

issued or the date the Commissioner files an answer or amended answer asserting

such penalty. Chai v. Commissioner, 

, 221 (2d Cir. 2017), aff’g in

part, rev’g in part T.C. Memo. 2015-42; see also Graev v. Commissioner, 149 T.C.

___ (Dec. 20, 2017), supplementing 147 T.C. __ (Nov. 30, 2016). Compliance

with section 6751(b)(1) is part of the Commissioner’s burden of production in any

deficiency case in which a penalty subject to section 6751(b)(1) is asserted. Chai

v. Commissioner, 851 F.3d at 221.

         The section 6662 accuracy-related penalties determined in the notices of

deficiency were properly approved as required by section 6751(b) and respondent

has proven sufficient facts to satisfy the burden of production and proof as to that

issue.
                                         - 23 -

[*23]         1.     Substantial Understatement of Income Tax

        An understatement is the excess of the tax required to be shown on the tax

return over the tax actually shown on the return, reduced by any rebates. Sec.

6662(d)(2)(A). An understatement of income tax is substantial if it exceeds the

greater of $5,000 or 10% of the tax required to be shown on the return in the case

of an individual. Sec. 6662(d)(1)(A). Understatements are reduced by the portion

attributable to (1) an item for which the taxpayer had substantial authority or (2)

any item for which the taxpayer, in the return or an attached statement, adequately

disclosed the relevant facts affecting the item’s tax treatment and the taxpayer had

a reasonable basis for the tax treatment of the item. Sec. 6662(d)(2)(B).

        The substantial authority standard is an objective standard that requires an

analysis of the law and relevant facts. Sec. 1.6662-4(d)(2), Income Tax Regs.

There is substantial authority for the tax treatment of an item only if the weight of

authorities supporting the treatment is substantial in relation to the weight of

authorities supporting contrary treatment. Sec. 1.6662-4(d)(3), Income Tax Regs.

        Petitioners’ understatement for each tax year is greater than both $5,000 and

10% of the tax required to be shown on the return, and thus respondent has met his

remaining burden of production through calculation. Neither the relevant law nor
                                          - 24 -

[*24] the facts as found in this opinion are supportive of petitioners’ position,11

and petitioners have not introduced any evidence that they disclosed on their

return the relevant facts affecting the tax treatment of items in question or that they

had a reasonable basis for such treatment. See sec. 6662(d)(2)(B). So, unless

petitioners had reasonable cause and acted in good faith with respect to the

underpayments under section 6664(c)(1), respondent’s determination regarding

this penalty must be sustained.

             2.     Negligence or Disregard of Rules and Regulations

      Alternatively, respondent argues that petitioners are liable for penalties

under section 6662(a) for negligence or disregard of rules and regulations, and

petitioners assert that they are not. For the sake of completeness, we address this

ground for imposing the penalty.

      “Negligence” includes any failure to make a reasonable attempt to comply

with the Internal Revenue Code and any failure to keep adequate books and

records or to substantiate items properly. Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. Negligence has also been defined as the failure to exercise due


      11
         Petitioners argue in their opening brief that “[b]ased on all the cases cited
herein, it is obvious that there is substantial legal justification for the position that
the loss is an ordinary loss”, which we interpret as an argument that substantial
authority exists for this tax treatment.
                                        - 25 -

[*25] care or the failure to do what a reasonable person would do under the

circumstances. See Allen v. Commissioner, 

, 12 (1989), aff’d, 

 (9th Cir. 1991). The term “disregard” includes any careless, reckless, or

intentional disregard. Sec. 6662(c). Disregard of rules or regulations is “careless”

if the taxpayer does not exercise reasonable diligence in determining the

correctness of a return position that is contrary to a rule or regulation. Sec.

1.6662-3(b)(2), Income Tax Regs. Disregard is “reckless” if the taxpayer makes

little or no effort to determine whether a rule or regulation exists, under

circumstances which demonstrate a substantial deviation from the standard of

conduct that a reasonable person would observe. Id. Disregard is “intentional” if

the taxpayer knows of the rule or regulation that is disregarded. Id.

      Petitioners’ original Federal income tax return for tax year 2009

characterized Wrentham House Mansion as a capital asset and claimed a lower

adjusted basis. Petitioners subsequently hired a different return preparer, Gabor &

Associates, to prepare amended returns that took a tax reporting position with

respect to Wrentham House Mansion that significantly reduced petitioners’

reported income tax liabilities for tax years 2004 through 2009. The amended

returns treated Wrentham House Mansion as a property used in an existing trade

or business, claimed a much higher adjusted basis, and claimed the NOL, which
                                          - 26 -

[*26] petitioners carried to other years to eliminate their tax liabilities for all the

years at issue.

       Petitioners’ quest for a better tax result was not supported by any

meaningful analysis of the merits of their new tax reporting position. Moreover,

petitioners knew that their planned rental activity had never commenced.

Respondent has met his remaining burden of production with respect to his

alternative penalty determination that petitioners were negligent.

              3.     Section 6664 Reasonable Cause and Good Faith Exception

       Section 6664(c)(1) provides an exception to the imposition of the accuracy-

related penalty if the taxpayer establishes that there was reasonable cause for, and

the taxpayer acted in good faith with respect to, the underpayment. Sec. 1.6664-

4(a), Income Tax Regs. The decision whether a taxpayer acted with reasonable

cause and in good faith is made on a case-by-case basis, taking into account all

pertinent facts and circumstances, including: (1) the taxpayer’s efforts to assess

the proper tax liability; (2) the knowledge and experience of the taxpayer; and (3)

reliance on the advice of a tax professional. Id. para. (b)(1). Generally, the most

important factor is the extent of the taxpayer’s efforts to assess his or her proper

tax liability. Id.
                                         - 27 -

[*27] Reliance on the advice of a tax professional or an honest misunderstanding

of the law that is reasonable in the light of the facts and circumstances may

support a conclusion that a taxpayer acted with reasonable cause and in good faith

with respect to a reported position. Id.; see Higbee v. Commissioner, 116 T.C. at

448-449. Reliance on the advice of a professional must be reasonable under the

circumstances. Sec. 1.6664-4(b)(i), Income Tax Regs.; see also Pasternak v.

Commissioner, 

, 903 (6th Cir. 1993), aff’g Donahue v.

Commissioner, T.C. Memo. 1991-181; Neonatology Assocs., P.A. v.

Commissioner, 

, 97-99 (2000), aff’d, 

 (3d Cir. 2002).

The advice must be based upon an analysis of all pertinent facts and the applicable

law and must not be based on unreasonable factual or legal assumptions. Sec.

1.6664-4(c)(1)(i) and (ii), Income Tax Regs. It cannot be based on an assumption

that the taxpayer knows, or has reason to know, is unlikely to be true. Id. subdiv.

(ii).

        Petitioners failed to prove that they had reasonable cause and acted in good

faith within the meaning of section 6664(c)(1). Petitioners did not make a

reasonable, good-faith effort to correctly assess their tax liabilities and their

claimed reliance on a tax professional was both unreasonable and not credible.

Petitioners’ attempt to recharacterize the tax treatment of their investment in
                                        - 28 -

[*28] Wrentham House Mansion was opportunistic and appears to have been

motivated by their financial problems and unpaid income tax liabilities. This

attempted recharacterization had all the markings of being “too good to be true”,

yet petitioners forged ahead, knowing that they had never actually commenced a

rental activity involving Wrentham House Mansion and had not done all of the

things the law required to be able to rent Wrentham House Mansion. Because

petitioners failed to prove that they had reasonable cause for, and acted in good

faith with respect to, the positions taken on their amended income tax returns and

on their only return for 2010, we sustain respondent’s determination that they are

liable for the section 6662 accuracy-related penalties.

V.    Conclusion

      We hold that: (1) Wrentham House Mansion was a capital asset in the

hands of petitioners; (2) section 263A requires that the designated interest

payments made on Wrentham House Mansion be capitalized; (3) petitioners are

liable for additions to tax under section 6651(a)(1) for failure to timely file Federal

income tax returns for tax years 2006 through 2008; and (4) petitioners are liable

for the section 6662 accuracy-related penalties as determined by respondent.
                                      - 29 -

[*29] In reaching our holdings herein, we have considered all arguments made by

the parties, and to the extent not mentioned above, we find them to be moot,

irrelevant, or without merit.

      To reflect the foregoing,


                                               Decisions will be entered

                                      under Rule 155.