CARLUZZO, Special Trial Judge.
This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code in effect when the petition was filed.
In a notice of deficiency dated August 21, 2009, respondent determined deficiencies of $23,706 and $27,653 in petitioners' 2006 and 2007 Federal income tax, respectively. The issue for decision for each year is whether petitioners are entitled to a deduction for a rental real estate loss. The resolution of the issue depends upon whether Peter H. Hofinga (petitioner) is a taxpayer described in section 469(c)(7) for either year in issue.
Some of the facts have been stipulated and are so found. At the time the petition was filed, petitioners resided in California.
Over the years after they married in 1982, petitioners purchased, and as necessary renovated and remodeled, residential real estate properties that they held for rent. As of the close of 2006, petitioners owned eight rental properties; as of the close of 2007, petitioners owned nine rental properties (collectively, rental properties). Because of an election they made for Federal income tax purposes, petitioners' interests in the rental properties are treated as one activity.
Before retiring in 1993 petitioner was employed as a soccer coach and professor of physical education by the University of California Irvine (UCI). He was not employed in any capacity during either year in issue. At all times relevant, Margaret M. Wong (Mrs. Wong) was also employed by UCI.
As between the two of them, petitioner was more responsible for the management of the rental properties. For the most part he did so from his den/office in petitioners' residence. Routinely and regularly he reviewed and paid various bills, considered and made arrangements for repairs, arranged for the purchase of supplies, reviewed rental applications, from time to time inspected a rental property for various reasons, and supervised and/or made the arrangements for renovating and remodeling a rental property when necessary. Neither petitioner, however, kept any sort of contemporaneous log or record that shows the amount of time either spent, or specific services either provided, with respect to any specific rental property on any specific date.
Petitioners also employed property managers for some of the rental properties. Routinely, the property managers were responsible for collecting rent, responding to inquiries or complaints from tenants, and making/supervising repairs, the costs of which did not exceed a designated amount set by petitioners. In addition to the fees paid to the property managers, a review of petitioners' Federal income tax returns for the years in issue shows deductions for expenses attributable to the rental properties for cleaning, maintenance, gardening, pest control, plumbers, electricians, and commissions.
On their 2006 and 2007 Federal income tax returns, petitioners deducted losses of $111,042 and $141,133, respectively, attributable to the rental properties (rental property losses). If the rental property losses are not taken into account, then petitioners' adjusted gross income as reported on each of those returns would exceed $150,000.
The rental property losses are disallowed in the notice of deficiency. According to respondent's explanation, "[r]ental activities of any kind, regardless of material participation, are considered passive activities unless the requirements of section 469(c)(7) of the Internal Revenue Code are met in tax years beginning after December 31, 1993". According to respondent, those "requirements", which will be more fully discussed below, have not been "met". Other adjustments made in the notice of deficiency are computational and will not be discussed.
The explanation for the disallowances of the rental property losses provided in the notice of deficiency includes terms of art, such as "material participation" and "passive activities", which are used and defined in section 469 and its corresponding regulations. In an article published in the October 24, 2011, edition of Tax Notes, Professor George S. Jackson states that section 469 contains "almost 4,500 words" (we did not count) and "exemplifies why federal tax law is incomprehensible for most citizens." George S. Jackson, "Passive Activity Limitations: Time for a New Paradigm?", 133 Tax Notes 447, 459 (2011). Describing section 469 as "incomprehensible" is probably an overstatement; that section, however, is hardly uncomplicated.
In general and as relevant here, an individual is not entitled to a deduction for a passive activity loss incurred during the taxable year.
In general, a rental activity is treated as a passive activity regardless of whether the taxpayer materially participates.
The relevant exception is found in section 469(c)(7). If a taxpayer is described in that section (sometimes that taxpayer is referred to as a "real estate professional"), then section 469(c)(2) does not apply and the taxpayer's rental real estate activity, if conducted as a trade or business or for the production of income, is not treated as a passive activity if the taxpayer materially participates in the activity. Sec. 469(c)(1);
We need not get into the complicated definition of the term "material participation" set forth in section 469(h) and its corresponding regulations. Keeping that definition in mind, and because petitioners elected to treat the rental properties as a single activity, we are satisfied that they materially participated in the rental property activity during each year in issue, and respondent does not seem to suggest otherwise. Instead, the disagreement between the parties focuses on whether petitioner is a taxpayer described in section 469(c)(7).
Section 469(c)(7) contains two tests that a taxpayer must satisfy to be described in that section. One requires that the taxpayer perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Ideally, a taxpayer who claims to be described in section 469(c)(7) would maintain a contemporaneous log or record showing with particularity the amount of time devoted to the rental real estate activity on an event-by-event basis.
Recognizing that many taxpayers might not be aware of the importance of keeping a contemporaneous log of time devoted to the taxpayer's rental real estate activity, the Commissioner's regulations provide a second-best alternative. Section 1.469-5T(f)(4), Temporary Income Tax Regs.,
Although petitioners did not maintain contemporaneous logs of the time devoted to their rental real estate activity, they tried to establish petitioner's participation by other reasonable means (e.g., noncontemporaneous logs based on petitioners' records) in compliance with section 1.469-5T(f)(4), Temporary Income Tax Regs.,
The estimates of time shown for some entries on the first set of logs Mrs. Wong prepared include a combination of time spent by both petitioners. For purposes of the 750-hour test, however, only the hours petitioner spent are taken into account.
On the other hand, some of the entries in the logs reference specific properties and provide a distinct description, such as:
Although we expect petitioners, in their role of landlords, expended significant time during each year in issue providing services in connection with the rental properties, we are unable, from what has been submitted, to quantify the total time that petitioner spent doing so, and we cannot ignore the deductions attributable to others' providing management and maintenance services in connection with the rental properties. Simply put, the logs do not allow for a review of activity related to the rental properties on an event-by-event basis to the extent necessary to establish that the 750-hour test has been satisfied.
Petitioners have failed to establish that petitioner satisfied the 750-hour test for either year in issue; consequently, petitioner is not a taxpayer described in section 469(c)(7) for either of those years. That being so, petitioners' rental real estate activity is treated as a passive activity for both of those years. It follows that respondent's disallowances of the rental property losses attributable to that activity are sustained.
To reflect the foregoing,
