                         T.C. Memo. 2014-135



                  UNITED STATES TAX COURT



    MICHAEL HUME AND DORSAYE DILANI, Petitioners v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 27294-11.                         Filed July 7, 2014.



       Ps claimed mortgage interest deductions on their 2008 and
2009 Schedules C, Profit or Loss From Business, for a property they
owned and had intended to rent out. R determined that Ps were not
entitled to Schedule C deductions, but rather the property was a
personal residence and Ps are able to deduct the mortgage interest
payments only as qualified residence interest deductions on their
Schedules A, Itemized Deductions, subject to the $1.1 million I.R.C.
sec. 163(h) limitation.

       Held: The mortgage interest P-H paid in 2008 and 2009 on Ps’
personal residence is not an ordinary business expense, but rather is
deductible as an itemized interest deduction on each Schedule A and
is subject to the qualified residence limitation of I.R.C. sec. 163(h).

      Held, further, P-H’s property at 420 Cazador Lane is a personal
residence.
                                        -2-

      [*2] Held, further, for each year in issue, P-H is able to deduct the
       interest paid with respect to an amount allocable to the $1.1 million
      of acquisition and home equity indebtedness, but R properly
      disallowed a deduction for the remaining mortgage interest paid.


      Michael Hume and Dorsaye Dilani, pro sese.

      Sebastian Voth, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      WHERRY, Judge: This case is before the Court on a petition for

redetermination of deficiencies in income tax respondent determined for

petitioners’ 2008 and 2009 tax years. Petitioners timely filed joint Federal income

tax returns for the 2008 and 2009 tax years. Respondent issued a notice of

deficiency on August 29, 2011, disallowing business expense deductions for

petitioners’ mortgage interest payments and allowing the mortgage interest

payments as qualified residence interest deductions on Schedules A, Itemized

Deductions, subject to the section 163(h)(3) limitation.1




      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code of 1986, as amended and in effect for the taxable years at issue.
All Rule references are to the Tax Court Rules of Practice and Procedure.
                                        -3-

[*3] After concessions by the parties,2 the issues for decision are: (1) whether

petitioners had a trade or business in 2008 or 2009 under section 162, which

would permit Mr. Hume to deduct the mortgage interest paid in relation to a house

at 420 Cazador Lane as an ordinary business expense; (2) if petitioners’ activities

do not qualify as a trade or business, whether petitioners can deduct mortgage

interest and home equity indebtedness interest paid on loans in excess of the

aggregate combined $1,100,000 loan limitation of section 163(h).




      2
        On December 17, 2012, and on March 13, 2013, the parties filed with the
Court stipulations of settled issues stating the following: (1) respondent concedes
the adjustments for 2008 and 2009 for unreimbursed employee expenses of
$20,318 and $11,354, respectively; (2) respondent concedes the accuracy-related
penalties under sec. 6662(a) for 2008 and 2009; (3) all income, capital losses,
itemized deductions, and the Schedules C, Profit or Loss From Business, included
in petitioners’ original Form 1040, U.S. Individual Income Tax Return, and Form
1040X, Amended U.S. Individual Income Tax Return, for petitioners’ 2008 tax
year are attributable to Mr. Hume; (4) Mr. Hume is entitled to two exemptions for
two of petitioners’ children for the 2008 and 2009 tax years; (5) all income,
Schedule C deductions, itemized deductions, and capital losses, except the
Schedule C income and deductions attributable to Ms. Dilani’s business, reported
on petitioners’ Forms 1040 and 1040X for their 2009 tax year are attributable to
Mr. Hume; (6) Mr. Hume and Ms. Dilani should have filed their 2008 and 2009
income tax returns with a filing status of single because their divorce was final
before the end of 2008, see sec. 6013(g)(4)(C); and (7) respondent waives seeking
an increased deficiency due to any potential change to petitioners’ proper filing
status for 2008 or 2009.
                                         -4-

[*4]                           FINDINGS OF FACT

       Some of the facts have been stipulated, and the stipulation of facts and

stipulation of settled issues and supplemental stipulation of settled issues with the

facts contained in their accompanying exhibits are hereby incorporated by

reference into our findings.

       During the years at issue and when they filed their Tax Court petition on

which this case is based, petitioners resided in separate homes in San Clemente,

California.

Background

       Mr. Hume worked full time in the sales division of Planet Antares Corp.

(Planet Antares). Planet Antares helped entrepreneurs start their own home-based

vending machine businesses. During 2008 and 2009 Mr. Hume traveled over 59

times to various parts of the United States and Canada in connection with his job.

Each business trip took an average of one week.

Properties

       In June of 2004 petitioners acquired a 4,437-square-foot single-family home

at 24 Calle Pacifica (Calle Pacifica) in San Clemente, California. Calle Pacifica

had 5 bedrooms and 4.5 baths. In 2004 petitioners and their three children were

living in Calle Pacifica. Mr. Hume moved out of Calle Pacifica in early 2006.
                                           -5-

[*5] Ms. Dilani and petitioners’ children continued to live in Calle Pacifica

through January 2012. Mr. Hume and Ms. Dilani were divorced on February 7,

2008.

        In August of 2005 petitioners purchased a single-family home at 420

Cazador Lane (Cazador) in San Clemente, California. Petitioners purchased

Cazador for $1,460,000, which was paid in part by a $1 million purchase money

mortgage loan from Countrywide Home Loans. The house was originally built for

Oscar nominee Ann Harding3 in 1926. Petitioners’ purchase of Cazador was

documented by a quitclaim deed. Petitioners did not have Cazador inspected by

engineers or other professionals before purchasing it. When petitioners purchased

Cazador, tenants were living there and paying a monthly rent significantly below

market. Petitioners ended the agreements with the tenants and caused the tenants

to move out of Cazador by early 2006.

        Petitioners purchased Cazador with the intent of renting it out for weekly

vacations and for events.4 At the time of purchase and at all times thereafter


        3
            Ann Harding is best known for her role in the movie “Holiday”.
        4
        In August 2005 petitioners contracted with PHG Management Co. to rent
and manage Cazador for them. Between September and November 2005
petitioners did receive rental income from Cazador; but after that the rental income
ceased, and the agreement with PHG Management Co. appears to have terminated
                                                                       (continued...)
                                        -6-

[*6] petitioners did not have a preexisting arrangement to rent or sell Cazador to

any specific parties. Petitioners acknowledged that they had purchased Cazador

without fully realizing the amount of work or the repair cost that was needed to

make Cazador suitable for potential renters. Cazador had many structural and

aesthetic problems, and petitioners were never able to get the property into

suitable shape for new tenants.

      Petitioners on December 6, 2005, contracted with the City of San Clemente

to preserve and maintain Cazador as a historic structure.5 The City of San

Clemente required that Cazador have certain structural changes and maintenance

performed in exchange for a lower property tax assessment. The historic

preservation agreement with the City of San Clemente did not include any

information indicating the renting or intent to rent out Cazador. During 2008 and




      4
       (...continued)
although the record is unclear on this point.
      5
       The California law commonly known as the Mills Act permits agreements
with at least a 10-year term between cities and property owners for historic
preservation and in exchange provides for certain property tax concessions to the
property owners. Specifically, it permits property tax valuation using the income
method described by Cal. Rev. & Tax. Code sec. 439.2 (West 1998 & Supp.
2014). See Cal. Gov’t Code secs. 50280-50290 (West 2002); see also Cal. Rev. &
Tax. Code sec. 439.
                                        -7-

[*7] 2009 petitioners did not rent nor did they advertise Cazador.6 Despite their

problems in carrying out the alleged rental plan during 2008 and 2009 petitioners

did not attempt to sell Cazador. During 2008 and 2009 Mr. Hume lived at

Cazador when he was not traveling. Petitioners never completed the renovations

before they sold the property on November 16, 2012.

Mortgage Interest and Equity Line

      On January 25, 2005, petitioners refinanced Calle Pacifica by obtaining a

mortgage loan for $995,000 from Washington Mutual Bank. On May 12, 2005,

petitioners received a home equity line of credit of $436,250 from Countrywide

Bank by using their equity in Calle Pacifica as collateral. Petitioners’ mortgage

loan refinance on Calle Pacifica had average loan balances of $1,064,000 and

$1,056,000 during the tax years 2008 and 2009, respectively. On February 16,

2007, petitioners refinanced Cazador by obtaining a $2,100,000 mortgage loan

from Washington Mutual Bank. Petitioners owned Cazador during both of the

years at issue.

      In 2008 petitioners paid home mortgage interest and points totaling

$153,568. In 2009 petitioners paid home mortgage interest and points totaling


      6
      In 2006, petitioners advertised Cazador in the San Clemente Times, but that
was before they realized how much work needed to be done on the property.
                                        -8-

[*8] $195,265. In 2008 and 2009 the average mortgages secured by the two

homes exceeded $3 million. Petitioners also had a home equity line of credit that

exceeded $400,000.

Tax Returns

      On petitioners’ 2008 Form 1040 they deducted home interest and points

totaling $153,568 on their Schedule A for the two San Clemente properties.

Petitioners also deducted $29,888 of interest arising from the equity line of credit

associated with Calle Pacifica. Petitioners filed Form 1040x for the 2008 tax year.

On petitioners’ amended return they moved the $102,807 mortgage interest

deduction associated with Cazador from their Schedule A to their Schedule C.7

      Petitioners filed a Form 1040 for their 2009 tax year and deducted $195,236

of claimed mortgage interest expense on their Schedule A for Cazador and Calle

Pacifica. Petitioners filed Form 1040x for the 2009 tax year that moved from their

Schedule A to their Schedule C the claimed interest deduction associated with

Cazador of $115,756.8 Respondent disallowed the mortgage interest and home


      7
      Remaining on petitioners’ Form 1040X Schedule A for 2008 was the
mortgage interest associated with Calle Pacifica of $48,856 and points paid of
$1,905.
      8
      Remaining on petitioners’ Form 1040X Schedule A for 2009 was the
mortgage interest associated with Calle Pacifica of $73,404 and points paid of
                                                                     (continued...)
                                        -9-

[*9] equity interest deductions petitioners claimed for taxable years 2008 and 2009

to the extent that the interest related to loan principal which exceeded the

aggregate $1.1 million cap applicable to the qualified residence interest deduction.

                                     OPINION

I.    Burden of Proof

      As a general rule, the Commissioner’s determination in the notice of

deficiency is presumed correct, and the taxpayer bears the burden of proving by a

preponderance of the evidence that the determination is improper. See Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Although section 7491(a)

may shift the burden of proof to the Commissioner in specified circumstances,

petitioners have not established that they meet the requirements under section

7491(a)(2) for such a shift. Consequently, the burden of proof remains on

petitioners.

      Deductions are a matter of legislative grace, and taxpayers bear the burden

of proving that they are entitled to any claimed deductions. Rule 142(a); see

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Taxpayers are required

to identify each deduction, maintain adequate records, substantiate each deduction,



      8
      (...continued)
$1,905.
                                       - 10 -

[*10] and show that they have met all requirements.9 Sec. 6001; Roberts v.

Commissioner, 62 T.C. 834, 836-837 (1974); sec. 1.6001-1(a), Income Tax Regs.

      To prove a deductible expense, the taxpayer must establish with credible

evidence not only the facts of the expenditure, but also the business purpose or

other deductible character of the expense. “Business expenses deductible from

gross income include the ordinary and necessary expenditures directly connected

with or pertaining to the taxpayer’s trade or business”. Sec. 1.162-1(a) Income

Tax Regs. A claimed business expense must be incurred primarily for business

rather than personal reasons. Walliser v. Commissioner, 72 T.C. 433, 437(1979);

Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201

(2d Cir. 1969). The required tax records must be retained as long as they may be

material in the administration of any internal revenue law. Sec. 1.6001-1(e),

Income Tax Regs. Further, there must be a proximate relationship between the

claimed expense and the business. See Walliser v. Commissioner, 72 T.C. at 437.

II.   Real Estate Activity

      In general, section 162(a) allows a deduction for all ordinary and necessary

expenses paid or incurred during the taxable year in carrying on a trade or


      9
       Strict substantiation rules for deductions other than those subject to sec.
274(d) scrutiny may, in some situations not present here, be relaxed by the Cohan
rule. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930).
                                       - 11 -

[*11] business. In order for an activity to be considered a taxpayer’s trade or

business for purposes of section 162, the activity must be conducted “with

continuity and regularity” and “the taxpayer’s primary purpose for engaging in the

activity must be for income or profit”. Commissioner v. Groetzinger, 480 U.S. 23,

35 (1987). Whether a taxpayer’s activities constitute the carrying on of a trade or

business requires an examination of the facts and circumstances of each case. Id.

at 36; Higgins v. Commissioner, 312 U.S. 212, 217 (1941); O’Donnell v.

Commissioner, 62 T.C. 781 (1974), aff’d without published opinion, 519 F.2d

1406 (7th Cir. 1975).

      Implicit in both section 162 and the regulations is that the taxpayer must be

established in a trade or business before any expenses are deductible. Link v.

Commissioner, 90 T.C. 460, 463 (1988), aff’d without published opinion, 869

F.2d 1491 (6th Cir. 1989). “A taxpayer is not carrying on a trade or business

under section 162(a) until the business is functioning as a going concern and

performing the activities for which it was organized.” Glotov v. Commissioner,

T.C. Memo. 2007-147; see also McKelvey v. Commissioner, T.C. Memo. 2002-

63, aff’d, 76 Fed. Appx. 806 (9th Cir. 2003).

      The first question before the Court for decision is whether petitioners’ 2008

and 2009 mortgage interest expenditures qualify as section 162 business expenses.
                                         - 12 -

[*12] It is respondent’s position that even though Mr. Hume paid these expenses,

they qualify, if at all, for the qualified residence interest deduction, as opposed to

constituting ordinary and necessary section 162 business expenses. In determining

whether these expenses are in fact section 162 business expenses, the threshold

question is: Did petitioners start actively engaging in their proposed rental

business by their taxable years 2008 and/or 2009?

      Whether a taxpayer is engaged in a trade or business is determined using a

facts and circumstances test under which courts have focused on the following

three factors that indicate the existence of a trade or business: (1) the taxpayer

undertook the activity intending to earn a profit; (2) the taxpayer is regularly and

actively involved in the activity; and (3) the taxpayer’s activity has actually

commenced. See McManus v. Commissioner, T.C. Memo. 1987-457, aff’d

without published opinion, 865 F.2d 255 (4th Cir. 1988). Mr. Hume testified, and

nothing in the record seems to suggest otherwise, that he purchased Cazador with

the purpose of renting out the property for profit. The record arguably reflects that

he may have regularly and actively engaged in efforts to further and promote the

activity although he also resided at Cazador when in Los Angeles. See generally

sec. 262(a) (prohibiting the deduction of personal living or family expenses unless
                                         - 13 -

[*13] explicitly authorized). However, it is the third factor, whether petitioners’

business had actually commenced, that is ultimately determinative here.

       While not conclusive, it is important to note that Mr. Hume derived no

income from and did not rent out Cazador in either of the two years at issue. Mr.

Hume testified that petitioners never were able to get Cazador into a “condition to

be able to” rent it. Additionally, Mr. Hume was living at Cazador during 2008 and

2009. Accordingly, his course of conduct was not consistent with that of a person

who believed he was renting or able to rent out the property during 2008 or 2009.

We conclude that during 2008 and 2009 petitioners had not yet restarted the prior

owner’s rental business that petitioners had abandoned in December 2005 and

therefore petitioners are not entitled to a section 162 deduction for 2008 or 2009.

       Consequently, the mortgage interest petitioners paid on the indebtedness

secured by Cazador and Calle Pacifica is not a section 162 ordinary business

expense, but rather is deductible, if at all, as qualified residence interest pursuant

to section 163(a) that is subject to the limitations of section 163(h).

III.   Qualified Residence Interest Deduction

       As a general rule, taxpayers may not deduct personal interest. Sec.

163(h)(1). A limited exception to this general rule permits individuals to deduct
                                        - 14 -

[*14] qualified residence interest. Sec. 163(h)(3). Section 163(h)(3)(A) defines

qualified residential interest as:

      any interest which is paid or accrued during the taxable year on

                   (i) acquisition indebtedness with respect to any qualified
      residence of the taxpayer, or

                   (ii) home equity indebtedness with respect to any
      qualified residence of the taxpayer.

Acquisition indebtedness is debt that is used to acquire, construct, or substantially

improve a “qualified residence” and that is secured by that residence. Sec.

163(h)(3)(B)(i). The aggregate amount treated as acquisition indebtedness for any

period cannot exceed $1 million ($500,000 for a married individual filing a

separate return). Sec. 163(h)(3)(B)(ii). Acquisition indebtedness includes debt

incurred in refinancing acquisition indebtedness, insofar as the new debt does not

exceed the refinanced debt. Sec. 163(h)(3)(B) (flush language). Home equity

indebtedness is the first $100,000 of debt ($50,000 for a married taxpayer filing

separately), other than acquisition indebtedness, secured by a “qualified residence”

so long as the debt does not exceed the fair market value of the residence reduced

by the qualified acquisition indebtedness. Sec. 163(h)(3)(C). As relevant here,

“qualified residence” means the taxpayer’s “principal residence” within the

meaning of section 121. Sec. 163(h)(4)(A)(i)(I). Section 121 does not define the
                                        - 15 -

[*15] term “principal residence” but, subject to various limitations, allows for the

exclusion of gain on the sale or exchange of property “owned and used by the

taxpayer as the taxpayer’s principal residence”. Sec. 121(a).

       For 2008 and 2009 Mr. Hume deducted mortgage interest on Calle Pacifica

and Cazador on an aggregate loan amount of more than $3 million. Respondent

conceded that Mr. Hume paid the mortgage interest on both Calle Pacifica and

Cazador. Generally, Mr. Hume would be eligible to claim a section 163(a) and (h)

deduction for the interest paid on $1.1 million of the loans;10 however, Mr. Hume

did not provide any evidence to show that he lived in Calle Pacifica for the

required 14 days during either 2008 or 2009. Sec. 163(h)(4)(A)(i)(II).

Accordingly, he may claim only the mortgage interest deduction with respect to

Cazador. Therefore, respondent properly disallowed the excess mortgage interest

paid with respect to loan amounts above $1.1 million. See sec. 163(h)(3)(B)(ii),

(C)(ii).




       10
        When Mr. Hume paid for the properties, he was divorced from Ms. Dilani;
and as divorced persons filing separate returns they may have otherwise both been
able to qualify for the full $1.1 million dollar deduction. However, petitioners did
not present any evidence to suggest that Ms. Dilani provided any of the mortgage
payments.
                                         - 16 -

[*16] IV.    Conclusion

      On the record as a whole the Court accepts respondent’s determination that

petitioners were not during 2008 and 2009 engaged in the business of renting out

Calle Pacifica or Cazador. Additionally, petitioners are not entitled to claim

interest deductions arising from their home loans to the extent the interest paid is

attributable to loan amounts above the $1.1 million section 163(h) limitation. As

noted in the stipulation of settled issues, petitioners do not have an increased

deficiency due to the statutory switching of their filing status for the 2008 and

2009 taxable years from married filing jointly to single.11 Additionally, as the joint

Federal income tax returns petitioners filed for 2008 and 2009 were impermissible

Ms. Dilani is not liable for the increased deficiency for the 2008 and 2009 tax

years, except to the extent, if any, that the deficiency relates to her separate

business income and deductions in 2009. See sec. 6013; sec. 1.6015-3(a), Income

Tax Regs.

                                                  Decision will be entered under

                                        Rule 155.




      11
       Petitioners’ filing of their joint Federal income tax returns for 2008 and
2009 was not permitted and therefore they are treated as filing separately. See sec.
6013(a); secs. 1.6013-(4)(a), 1.6013-6(b)(3), Income Tax Regs.
