                  T.C. Summary Opinion 2006-57



                     UNITED STATES TAX COURT



          EDWARD C. AND SUSAN R. HANNA, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19033-03S.         Filed April 19, 2006.


     Edward C. and Susan R. Hanna, pro sese.

     Lauren B. Epstein, for respondent.



     PANUTHOS, Chief Special Trial Judge:   This case was heard

pursuant to the provisions of section 7463 of the Internal

Revenue Code in effect at the time the petition was filed.   The

decision to be entered is not reviewable by any other court, and

this opinion should not be cited as authority.   Unless otherwise

indicated, subsequent section references are to the Internal

Revenue Code in effect for the year in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.
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     Respondent determined a $26,693 deficiency in petitioners’

2000 Federal income tax and a $5,338.60 penalty pursuant to

section 6662(a).    The issues for decision are:   (1) Whether the

passive activity rules of section 469 preclude petitioners from

deducting losses from their rental real estate activities in the

taxable year 2000, and (2) whether petitioners are liable under

section 6662(a) for an accuracy-related penalty.

     Some of the facts have been stipulated, and they are so

found.    The stipulation of facts, supplemental stipulation of

facts, and attached exhibits, as well as additional exhibits

admitted during trial, are incorporated herein by this reference.

Petitioners Susan Hanna (Mrs. Hanna) and Edward Hanna (Mr. Hanna)

are married and resided in Sanibel, Florida, when they filed

their petition.    For convenience, we combine our findings and

discussion herein.

     Sanibel is a popular vacation spot located on an island off

the west coast of Florida.    In 1999, petitioners purchased two

houses in Sanibel and began renting them to vacationers.     In

2000, petitioners rented the first house for a total of 20 weeks

and the second house for a total of 19 weeks.      Petitioners also

purchased a third house in Sanibel in May 2000, which they

immediately leased back to the sellers for the remainder of that

year.    For convenience, we refer to the management and operation

of the three properties as the “rental activities”.

     Petitioners did not live in Sanibel in 2000.     Instead, they
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operated their rental activities from their home in Weston,

Massachusetts.   Petitioners received on-site assistance from

George Veillette, a Sanibel resident and real estate agent who

sold petitioners their first two rental properties.      Mr.

Veillette periodically checked the properties when they were

vacant to make sure the premises were secure, and the water and

heat systems were functioning.    He also supplied keys to

repairmen and, on rare occasions, to renters.      Mr. Veillette

estimated he spent a total of approximately 6 hours a month

looking after the properties.

     Although petitioners both spent time on the rental

activities, Mrs. Hanna performed the majority of the work.         She

designed and constructed one or more Internet Web sites to help

advertise the properties, designed and placed advertisements in

newspapers, responded to e-mails from prospective customers, and

performed a number of other tasks.       Petitioners traveled to

Florida five times in 2000, spending a total of approximately 5

weeks there.   During their visits petitioners looked for

additional properties to buy, met potential customers, and

arranged for cleaning, maintenance, and repairs for their

existing properties.

     In addition to managing their rental activities in 2000,

both petitioners worked full time in the Boston, Massachusetts,

metropolitan area.   Mr. Hanna worked as a project manager for

Fidelity Investments, earning a salary of $125,371 for
                                 - 4 -

approximately 2,000 hours of work.       Mrs. Hanna worked as a

computer consultant for three different companies, earning

$123,270 for 2,119 hours of work.

     Petitioners filed a joint 2000 Federal income tax return.

On Schedule E, Supplemental Income and Loss, petitioners reported

$46,210 of gross income from the rental activities, and $118,057

of expenses and depreciation, for a loss of $71,847.       Although

respondent did not adjust any of the Schedule E items of income,

expense or depreciation, he determined that the $71,847 loss was

a nondeductible passive activity loss.       Respondent also

determined that petitioners were liable for an accuracy-related

penalty under section 6662(a).

Burden of Proof

     Deductions are a matter of legislative grace, and a taxpayer

generally bears the burden of proving that he or she is entitled

to the deductions claimed.   See Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79 (1992); New Colonial Ice Co. v.

Helvering, 292 U.S. 435 (1934).    The taxpayer is required to

maintain records that are sufficient to enable the Commissioner

to determine his or her correct tax liability.       See sec. 6001;

sec. 1.6001-1(a), Income Tax Regs.
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     The Commissioner’s determinations set forth in a notice of

deficiency generally are presumed correct, and the taxpayer bears

the burden of showing that the determinations are in error.     Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).     Pursuant

to section 7491(a), the burden of proof as to factual matters

shifts to the Commissioner where the taxpayer complies with

substantiation requirements, maintains records, and cooperates

fully with reasonable requests for witnesses, documents, and

other information.

     Petitioners contend that the burden of proof shifts to

respondent.   Broadly construed, their argument appears to be:

(1) They fully cooperated with respondent by providing copies of

their records to him, and (2) respondent conceded in a letter

that respondent bears the burden of proof.

     Based on our review of the record, we conclude that

petitioners fully cooperated with respondent’s requests for

documents and other information.   “For the burden to be placed on

the Commissioner, however, the taxpayer must comply with the

substantiation and record-keeping requirements of the Internal

Revenue Code.”   Higbee v. Commissioner, 116 T.C. 438, 441 (2001).

For the reasons discussed infra, petitioners did not comply with

these requirements.   Accordingly, this argument fails.

     Petitioners also rely on a letter from respondent dated June

2, 2003.   The letter informs petitioners that the statute of

limitations period for assessing their 2000 Federal tax liability
                               - 6 -

will expire soon and requests that they sign and return a Form

872, Consent to Extend the Time to Assess Tax.    It also describes

petitioners’ rights, including their right to withhold consent.

The letter states:   “It may be considered that you have

cooperated with the Internal Revenue Service, for purposes of

determining who has the burden of proof in any court proceeding,

even if you do not sign the consent form.”    Petitioners believe

that this constitutes a concession by respondent that he bears

the burden of proof.   We disagree.

     In general, the Government must assess tax within 3 years

after the due date of a timely filed return.    Sec. 6501(a) and

(b)(1).   The Secretary and a taxpayer can consent to extend the

assessment period, but the Secretary must notify the taxpayer of

the taxpayer’s right to withhold such consent.    Sec.

6501(c)(4)(A) and (B).   Respondent’s letter informs petitioners

of their rights, but it does not concede that respondent bears

the burden of proof.   Rather, it explains that withholding

consent is not considered in deciding whether petitioners

cooperated fully with reasonable requests for witnesses,

documents, and other information.     The letter does not cause the

burden of proof to shift to respondent, and petitioners’ reliance

on the letter therefore is misplaced.
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Loss From Rental Activities

     Section 469 generally disallows for the taxable year any

passive activity loss.    Sec. 469(a).   A passive activity loss is

defined as the excess of the aggregate losses from all passive

activities for the taxable year over the aggregate income from

all passive activities for that year.    Sec. 469(d)(1).    A passive

activity is any trade or business in which the taxpayer does not

materially participate.    Sec. 469(c)(1).   Rental activity

generally is treated as a per se passive activity regardless of

whether the taxpayer materially participates.     Sec.

469(c)(2),(4).   Under section 469(c)(7)(B), however, the rental

activity of a taxpayer in a real property trade or business (real

estate professional) is not per se passive activity.     Instead, it

is treated as a trade or business and subject to the material

participation requirements of section 469(c)(1).     Sec.

1.469-9(e)(1), Income Tax Regs.

     A taxpayer qualifies as a real estate professional and is

not engaged in a passive activity if:

          (i) more than one-half of the personal services
     performed in trades or businesses by the taxpayer
     during such taxable year are performed in real property
     trades or businesses in which the taxpayer materially
     participates, and

          (ii) such taxpayer performs more than 750 hours of
     services during the taxable year in real property
     trades or businesses in which the taxpayer materially
     participates.

Sec. 469(c)(7)(B).   A trade or business includes being an
                                 - 8 -

employee.   Putoma Corp. v. Commissioner, 66 T.C. 652, 673 (1976),

affd. 601 F.2d 734 (5th Cir. 1979); Fowler v. Commissioner, T.C.

Memo. 2002-223.   In the case of a joint return, the same spouse

must satisfy each requirement.    Sec. 469(c)(7)(B).

     In the present case, the parties agree that petitioners’

rental activities constituted a real property trade or business

and that Mr. Hanna was not a real estate professional.   They

dispute whether Mrs. Hanna qualified as a real estate

professional.   Accordingly, we focus on whether Mrs. Hanna’s

participation in the rental activities meets the requirements of

section 469(c)(7)(B).

     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.

This Court has acknowledged that these temporary regulations are

somewhat ambiguous concerning the records a taxpayer needs to

maintain, but we have held that they do not allow a post-event

“ballpark guesstimate”.   Fowler v. Commissioner, supra; Goshorn

v. Commissioner, T.C. Memo. 1993-578.

     Mrs. Hanna did not keep a contemporaneous log of the time
                                 - 9 -

she spent on the rental activities.       Petitioners did produce a

number of documents, however, including more than 400 pages of

e-mail messages sent to and from an e-mail account they

maintained for the rental activities, sales and marketing

materials they developed, a “cost analysis” and “cash flow

analysis” they prepared, and various other documents relating to

the rental activities such as photographs, worksheets,

handwritten notes, receipts, and correspondence.

     Petitioners also produced two summaries of the time spent on

the rental activities.   The first summary is titled “Susan

Hanna’s Activity for Year 2000” and indicates that Mrs. Hanna

spent 3,247 hours on rental activities.      This document does not

indicate when it was prepared.    The second document is an 89-page

“narrative summary” of each petitioner’s rental activities that

they created shortly before trial.       This document indicates that

Mrs. Hanna spent 2,610 hours on rental activities in 2000.

     Petitioners did not explain the discrepancy between the two

summaries.   Petitioners’ pretrial memorandum lists the 2,610-hour

figure, however, and petitioners consistently used that figure at

trial.   Furthermore, petitioners made frequent reference to the

89-page narrative summary during their testimony.      Accordingly,

we assume that petitioners’ position is that Mrs. Hanna worked

2,610 hours on rental activities in 2000.      The narrative summary

provides the following breakdown of those hours:

           Category                           Hours
                              - 10 -

          Advertising                     123
          Administrative and management   867
          Correspondence                  138
          Web site                        814
          Site visit                      256
          Purchasing                      244
          Acquisition                     168
           Total                        2,610

     Petitioners calculated the hours reflected in the narrative

summary by applying a “minimal standard” to the various tasks

Mrs. Hanna performed.    For example, petitioners contend that

Mrs. Hanna spent an hour a day checking the e-mail account for

the rental activities to identify potential customers and delete

unwanted e-mails.    Petitioners arrived at this figure by

measuring the time Mrs. Hanna spent performing the same task in

2005.   They believe this method provides an accurate estimate of

Mrs. Hanna’s time, even though petitioners owned four additional

rental properties in 2005.    Petitioners also contend that it

took Mrs. Hanna an average of 10 minutes to respond to each

e-mail they received from potential customers.    They believe

this results in a conservative estimate of their time because

some relevant e-mails had been deleted in 2000 and thus were not

made part of the record.    Petitioners argue that it also took

Mrs. Hanna 10 minutes to pay each bill they received because she

often had to contact the billing company to correct errors on

the invoices.

     Mrs. Hanna added a number of new pages to their Internet

Web sites in 2000.    Petitioners contend that each Web page took
                                - 11 -

Mrs. Hanna 4 hours to construct and additional time each month

to maintain.   During their visits to Florida in 2000,

petitioners contend Mrs. Hanna spent 60 percent of her waking

hours on rental activities.    Mrs. Hanna admitted this last

figure was the result of “guesstimating”, but she maintained

that the 89-page narrative summary provided a more accurate

estimate of the time she spent on the rental activities in 2000.

     Applying the test of section 469(c)(7)(B) to the facts of

this case, petitioners first must prove that more than one-half

of Mrs. Hanna’s personal services performed in trades or

businesses were performed in real property trades or businesses.

See sec. 469(c)(7)(B)(i).     Because Mrs. Hanna was paid for 2,119

hours of work as a computer consultant, she must have spent more

than that amount of time performing services for the rental

activities.

     Petitioners argue that Mrs. Hanna satisfied this

requirement because she performed 2,610 hours of services in the

rental activities.   As described above, however, petitioners did

not calculate this figure by reference to appointment books or

calendars.    In fact, Mrs. Hanna admitted that she was not good

at recording the time she spent on the rental activities.

Furthermore, although petitioners produced a narrative summary,

the accuracy of this document is suspect.    Petitioners prepared

the narrative summary shortly before trial, approximately 5

years after the events in question occurred.    More importantly,
                              - 12 -

the hours reflected in the document do not appear reasonable.

For example, one entry states that Mrs. Hanna and Mr. Hanna

spent a total of 80 hours preparing their Schedule E and Form

4562, Depreciation and Amortization, for their 1999 Federal

income tax return.   Considering that petitioners owned only two

rental properties in 1999, this estimate appears excessive.   We

are also skeptical that Mrs. Hanna spent an average of 10

minutes to read and respond to an e-mail or to pay a bill.

Finally, the discrepancy between the figures reflected in the

narrative summary and those in the document titled “Susan

Hanna’s Activity for Year 2000” casts further doubt on the

process by which petitioners calculated Mrs. Hanna’s rental

activities hours.

      We conclude that the method petitioners used to calculate

Mrs. Hanna’s participation in the rental activities constitutes

an impermissible “ballpark guesstimate”.    See, e.g., Fowler v.

Commissioner, T.C. Memo. 2002-223.     Petitioners have not

established by reasonable means that Mrs. Hanna performed more

than one-half of her personal services in real property trades

or businesses in 2000.1   Because Mrs. Hanna did not qualify as a

     1
       Petitioners argue that although Mrs. Hanna was paid for
2,119 hours of employment, she worked only 1,850 hours. They
attribute the difference to paid vacation, severance pay, and
“billing for hours not really worked”. Even if we accepted the
1,850-hour figure, our conclusion would not change because
petitioners’ method of calculation would still be an
impermissible “ballpark guesstimate”. Furthermore, while Mrs.
                                                   (continued...)
                              - 13 -

real estate professional, we need not consider whether she

materially participated in the rental activities.     See sec.

469(c)(7)(B).

      Although petitioners did not raise the issue, we note that

section 469(i) provides an exception to the general rule that

passive activity losses are disallowed.     A taxpayer who

“actively participates” in a rental real estate activity can

deduct a maximum loss of $25,000 per year related to the

activity.   Sec. 469(i)(1) and (2).    This exception is fully

phased out, however, when adjusted gross income (AGI) equals or

exceeds $150,000.   Sec. 469(i)(3)(A), (E).    Petitioners reported

AGI of $179,359.2   Accordingly, they cannot deduct any amount of




      1
      (...continued)
Hanna testified that overbilling was common among computer
consultants in her position, this practice raises the question of
whether she also inflated the hours reflected in the narrative
summary.
     2
       Under sec. 469(i)(3)(E)(iv), adjusted gross income (AGI)
is determined without regard to any passive activity loss or any
loss allowable by reason of sec. 469(c)(7). We do not address
the application of sec. 469(i)(3)(E)(iv) to the present case
because the AGI that petitioners reported already exceeds the
$150,000 limitation.
                               - 14 -

the passive activity loss in 2000.      Respondent’s determination

is sustained.

Accuracy-Related Penalty Under Section 6662(a)

     Section 6662(a) provides that a taxpayer may be liable for

a penalty of 20 percent of the portion of an underpayment of tax

attributable to (1) a substantial understatement of tax or (2)

negligence or disregard of rules or regulations.      Sec. 6662(a),

(b)(1) and (2).   An “understatement of tax” is substantial if it

exceeds the greater of 10 percent of the tax required to be

shown on the return or $5,000.    Sec. 6662(d)(1) and (2).     The

term “negligence” includes any failure to make a reasonable

attempt to comply with the provisions of the Internal Revenue

Code.   Sec. 6662(c).   The term “disregard” includes any

careless, reckless, or intentional disregard.      Id.   Respondent

has the burden of production with respect to the

accuracy-related penalty.    See sec. 7491(c).

     In the present case, 10 percent of the tax required to be

shown on petitioners’ return was $5,592.90.      Petitioners

understated their tax by $26,693.    Respondent therefore has met

his burden of production.

     An exception to the section 6662 penalty applies when the

taxpayer demonstrates (1) there was reasonable cause for the

underpayment, and (2) the taxpayer acted in good faith with

respect to the underpayment.    Sec. 6664(c).    Whether the

taxpayer acted with reasonable cause and in good faith is
                              - 15 -

determined by the relevant facts and circumstances on a

case-by-case basis.   See Stubblefield v. Commissioner, T.C.

Memo. 1996-537; sec. 1.6664-4(b)(1), Income Tax Regs.

“Circumstances that may indicate reasonable cause and good faith

include an honest misunderstanding of fact or law that is

reasonable in light of all the facts and circumstances,

including the experience, knowledge and education of the

taxpayer.”   Sec. 1.6664-4(b)(1), Income Tax Regs.   A taxpayer is

not subject to the addition to tax for negligence where the

taxpayer makes honest mistakes in complex matters, but the

taxpayer must take reasonable steps to determine the law and to

comply with it.   Niedringhaus v. Commissioner, 99 T.C. 202, 222

(1992).   The most important factor is the extent of the

taxpayer’s effort to assess the proper tax liability.

Stubblefield v. Commissioner, supra; sec. 1.6664-4(b)(1), Income

Tax Regs.

     At trial, respondent’s counsel acknowledged that the

provisions under section 469 are complicated.   Petitioners had

limited experience with these provisions in 2000 because they

had begun their rental activities only a year earlier.

Furthermore, despite working full-time jobs in addition to the

rental activities, petitioners created and/or maintained a

number of records relating to the rental activities, such as

e-mails, receipts, and correspondence.   Although these records

fail to establish that Mrs. Hanna was a real estate
                              - 16 -

professional, they do establish that petitioners made an honest

effort to comply with the substantiation requirements and assess

their proper tax liability.   Petitioners have shown reasonable

cause for the underpayment and demonstrated that they were

acting in good faith.   Accordingly, we conclude that petitioners

are not liable for the accuracy-related penalty under section

6662(a).

     Reviewed and adopted as the report of the Small Tax Case

Division.

     To reflect the foregoing,


                                      Decision will be entered

                                 for respondent as to the

                                 deficiency and for petitioners as

                                 to the accuracy-related penalty

                                 under section 6662(a).
