                         T.C. Summary Opinion 2012-30



                        UNITED STATES TAX COURT



          DENNIS MANALO AND NERISSA MANALO, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 17261-10S.                        Filed April 9, 2012.



      Lawrence T. Ullmann, for petitioners.

      Melissa C. Quale and Tyler N. Orlowski, for respondent.



                             SUMMARY OPINION


      ARMEN, Special Trial Judge: This case was heard pursuant to the

provisions of section 7463 of the Internal Revenue Code in effect when the
                                         -2-

petition was filed.1 Pursuant to section 7463(b), the decision to be entered is not

reviewable by any other court, and this opinion shall not be treated as precedent for

any other case.

      Respondent determined deficiencies in, and accuracy-related penalties with

respect to, petitioners’ Federal income taxes as follows:

             Year         Deficiency           Penalty - Sec. 6662(a)

             2007         $21,561.00           $4,312.20
             2008          25,461.00            5,092.20

      After concessions by petitioners,2 the issues before the Court are as follows:

      (1) Whether petitioners are entitled to deduct rental real estate losses after

passive limitations for 2007 and 2008 of $74,518 and $87,491, respectively; and

      (2) whether petitioners are liable for accuracy-related penalties under section

6662(a).

      1
         Unless otherwise indicated, all subsequent section references are to the
Internal Revenue Code in effect for the years in issue, all Rule references are to the
Tax Court Rules of Practice and Procedure, and all monetary amounts are rounded
to the nearest dollar.
      2
         Petitioners concede that they are not entitled to the following deductions
claimed on their Schedule C, Profit or Loss From Business, for 2007: (1) $20,000
for repairs and maintenance; (2) $10,872 for mortgage interest; and (3) $46,536 for
other expenses. Petitioners also concede that they are not entitled to the following
deductions claimed for 2008: (1) $30,959 for home mortgage interest claimed on
their Schedule A, Itemized Deductions; and (2) $12,508 for depreciation and sec.
179 expense claimed on their Schedule C.
                                          -3-

                                      Background

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

incorporate by reference the parties’ stipulation of settled issues, stipulation of facts,

supplemental stipulation of facts, and accompanying exhibits. Petitioners resided in

the State of California when the petition was filed.

      During the years in issue petitioners Dennis Manalo and Nerissa Manalo

owned two residential rental properties that gave rise to rental real estate losses, as

described infra. The first property was located on Prosperity Street in Mountain

House, California (Mountain House property) and the second was located on 16th

Avenue in San Francisco, California (16th Avenue property). Petitioners sometimes

arranged for others to provide services in connection with their rental properties

which services included showing the properties, collecting rent, and making repairs.

Petitioners, however, were always responsible for approving repair expenditures,

deciding on rental terms, and approving new tenants.

      At all times relevant, Mrs. Manalo was licensed by the State of California as

a real estate broker. In addition to helping manage petitioners’ rental properties

during the years in issue, Mrs. Manalo worked as a designated real estate broker

performing services related to nonrental real estate activities.
                                          -4-

      Petitioners did not maintain a contemporaneous time log that detailed their

real estate activities. Mrs. Manalo, however, did maintain desk calendars during the

years in issue (calendars) on which she recorded various appointments and tasks

associated with both her rental and nonrental real estate activities.

      Petitioners timely filed a joint Federal income tax return for each year in

issue. Petitioners attached to each of those returns a Schedule E, Supplemental

Income and Loss, on which they claimed rental real estate losses in respect of both

the Mountain House property and the 16th Avenue property.

      In 2009 respondent examined petitioners’ 2007 and 2008 Federal income tax

returns. During the course of the examination petitioners submitted the calendars

and a log of hours reconstructed on the basis of the notations in the calendars

(original log) to respondent’s revenue agent. The original log reported 89 hours and

72 hours spent on the Mountain House and 16th Avenue properties, respectively, in

2007. The original log also reported 6 hours and 60 hours in connection with the

same two properties, respectively, for 2008.

      Mrs. Manalo subsequently submitted three revised versions of the original log

(revised logs) to respondent over a two-year period, the final version of which was

submitted just before trial. The estimates on the revised logs included 113 hours

and 96 hours performed in connection with the Mountain House and 16th Avenue
                                         -5-

properties, respectively and a total of 271 hours reported in a new entry entitled

“Admin and Field” for 2007. The estimates on the revised logs also included 59

hours and 197 hours performed in connection with the same properties, respectively,

and a total of approximately 253 hours reported in the new “Admin and Field” entry

for 2008.

      The estimates on the revised logs are based on emails and archived

documents that were not offered into evidence by petitioners.

                                     Discussion

A. Burden of Proof

      In general, the Commissioner’s determinations set forth in a notice of

deficiency are presumed to be correct, and the taxpayer bears the burden of showing

that those 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 under certain circumstances. Petitioners have

neither alleged that section 7491(a) applies, nor have they established their

compliance with its requirements. Accordingly, petitioners bear the burden of

proof. See Rule 142(a); Welch v. Helvering, 290 U.S. at 115.
                                          -6-

B. Section 469

      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” includes,

with certain exceptions, any trade or business in which the taxpayer does not

materially participate. Sec. 469(c)(1). Rental activity is generally treated as a per

se passive activity regardless of whether the taxpayer materially participates. Sec.

469(c)(2), (4).

      There are two primary exceptions that operate to allow the current

deductibility of losses associated with rental activities that ordinarily would be

disallowed under section 469. Moss v. Commissioner, 135 T.C. 365, 368 (2010).

      1. Real Estate Professional

      The first exception is found in section 469(c)(7). Under that paragraph, the

rental activities of taxpayers in real property trades or businesses (so-called real

estate professionals) are not treated as per se passive activities but rather as trade or

business activities, subject to the material participation requirements of section

469(c)(1). Sec. 469(c)(7); see also sec. 1.469-9(e)(1), Income Tax Regs.
                                          -7-

      A taxpayer qualifies as a real estate professional whose rental activities are

not deemed per se passive 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). For joint filers, such as petitioners, the same spouse must satisfy

each of the above conjunctive requirements. Id.

      We have held, however, that even if a taxpayer would otherwise qualify as a

real estate professional under section 469(c)(7)(B), the taxpayer must still

“materially participate” in the taxpayer’s rental real estate activities in order to

deduct losses associated with those activities. See Perez v. Commissioner, T.C.

Memo. 2010-232; see also Shiekh v. Commissioner, T.C. Memo. 2010-126.

      In general, material participation is defined as regular, continuous, and

substantial involvement by an individual in the operations of an activity.3 Sec.

469(h)(1). The Commissioner’s temporary regulations generally provide seven

      3
         An individual must establish that he or she materially participated in each of
the rental activities unless the individual makes an election to treat all interests in
rental real estate as a single rental activity. Sec. 1.469-9(e)(1), Income Tax Regs.
Petitioners concede they made no such election.
                                          -8-

“safe-harbor” tests in which an individual will be treated, for purposes of section

469 and the regulations thereunder, as materially participating in a rental activity.

See sec. 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25,

1988).4 Under section 1.469-5T(a)(3), Temporary Income Tax Regs., supra, an

individual may meet the material participation requirement by demonstrating that the

individual participated in the rental activity for more than 100 hours during the

taxable year and that such individual’s participation is not less than the participation

of any other individual (including individuals who are not owners of interests in the

activity) during that year.

      For purposes of the material participation requirement, participation by an

individual’s spouse can be added to the participation of the individual. Sec.

469(h)(5). Individuals may establish the extent of their participation in an activity

by “any reasonable means”. Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53

Fed. Reg. 5727 (Feb. 25, 1988). Although “reasonable means” is interpreted

broadly, we have held that the phrase does not include a postevent “‘ballpark




      4
        Temporary regulations are entitled to the same weight as final regulations.
See Peterson Marital Trust v. Commissioner, 102 T.C. 790, 797 (1994), aff’d, 78
F.3d 795 (2d Cir. 1996); Truck & Equip. Corp. v. Commissioner, 98 T.C. 141, 149
(1992).
                                           -9-

guesstimate’”. Speer v. Commissioner, T.C. Memo. 1996-323 (quoting Goshorn v.

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

      Petitioners’ position is that Mrs. Manalo qualified as a real estate professional

and materially participated in petitioners’ rental real estate activities during the years

in issue.5 We find overall, however, that the means by which petitioners estimated

the time they spent performing services in their rental real estate activities were not

reasonable within the meaning of section 1.469-5T(f)(4), Temporary Income Tax

Regs., supra.

       Petitioners rely on section 1.469-5T(a)(3) of the temporary regulation to

establish Mrs. Manalo’s material participation, alleging that Mrs. Manalo spent

more than 100 hours performing personal services in each of petitioners’ rental real

estate activities and that her participation is not less than that of any other

individual. To support their position, petitioners rely on Mrs. Manalo’s calendars,

which according to petitioners were prepared contemporaneously with the

appointments noted therein. In addition, petitioners rely on the original log, a

reconstructed schedule of hours loosely based on the notations in the calendars.




      5
         The parties agree that Mr. Manalo did not qualify as a real estate
professional under sec. 469(c)(7)(B) during the years in issue.
                                          - 10 -

Those documents, however, do not establish that Mrs. Manalo spent more than 100

hours in each of petitioners’ rental real estate activities.

       To push themselves over the 100-hour hurdle, petitioners introduced at trial

three revised logs, including a last-minute log purporting to be a reconstruction of

the hours of services Mr. Manalo performed with respect to the rental activities.

The estimates in these revised logs, however, are uncorroborated and unreliable.

The revised logs were prepared at various instances over a two-year period after the

conclusion of respondent’s examination and are, according to petitioners, based on

emails and archived documents. Those emails and archived documents, however,

were never introduced into evidence at trial. “The rule is well established that the

failure of a party to introduce evidence within his possession and which, if true,

would be favorable to him, gives rise to the presumption that if produced it would

be unfavorable.” Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158,

1165 (1946), aff’d, 162 F.2d 513 (10th Cir. 1947).

       Petitioners’ revised logs draw further skepticism with respect to reliability in

that the hours reported appear excessive in relation to the work performed and many

descriptions do not specify the rental property that the hours relate to or who

performed the services described. The estimates on the revised logs appear to be

more akin to the unacceptable ballpark guesstimates that we have rejected in the
                                         - 11 -

past. See Speer v. Commissioner, T.C. Memo. 1996-323. Moreover, although we

found petitioners to be generally credible, the Court is not bound to accept as gospel

the unverified and undocumented testimony of a taxpayer. Tokarski v.

Commissioner, 87 T.C. 74, 77 (1986). Therefore, we conclude that petitioners have

failed to satisfy the safe harbor test provided in section 1.469-5T(a)(3), Temporary

Income Tax Regs., supra. 6

      In sum, on the record before us, we are unable to conclude that petitioners

have proven that Mrs. Manalo materially participated in either of petitioners’ rental

real estate activities.7 Accordingly, we hold that petitioners are not entitled to

deduct their rental real estate losses for 2007 or 2008 on the basis of the real estate

professional exception provided by section 469(c)(7).8




      6
        Although never asserted by petitioners at trial or on brief, we conclude,
based on all the facts and circumstances, that petitioners have also failed to satisfy
the remaining safe harbor tests provided in sec. 1.469-5T(a), Temporary Income
Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988).
      7
          Because we hold that petitioners did not materially participate in their rental
real estate activities, we need not discuss the remaining requirements under sec.
469(c)(7)(B), e.g., the 750-hour requirement.
      8
         We note, however, that surplus passive activity losses disallowed in
previous years may be available to offset other income in later years if a taxpayer’s
“entire interest in any passive activity” is “dispose[d] of” in a taxable transaction.
Sec. 469(g).
                                          - 12 -

       2. Offset for Rental Real Estate Activities

       The second exception that operates to allow the current deductibility of losses

associated with rental activities ordinarily disallowed under section 469, albeit a

potentially limited exception, is found in section 469(i). Even if a taxpayer’s rental

real estate activities are treated as passive activities, a portion of the passive activity

losses associated with those activities may still be allowed under section 469(i)(1).

Thus, a taxpayer who “actively” participates in a rental real estate activity may

deduct a maximum loss of $25,000 per year related to the activity. See sec.

469(i)(1) and (2). This exception is subject to phaseout when a taxpayer’s adjusted

gross income (determined without regard to any passive activity loss) exceeds

$100,000 and phases out entirely when adjusted gross income reaches $150,000 or

more. Sec. 469(i)(3)(A); Moss v. Commissioner, 135 T.C. at 371.

       Active participation is a lower standard than material participation and can

be satisfied without regular, continuous, and substantial involvement in an

activity. See Madler v. Commissioner, T.C. Memo. 1998-112. The active

participation standard is satisfied if the taxpayer participates in a significant and

bona fide sense in making management decisions (such as approving new tenants,
                                          - 13 -

deciding on rental terms, approving capital expenditures) or arranging for others to

provide services such as repairs. See id.

      It is clear that petitioners own the Mountain House property and the 16th

Avenue property and that they were responsible for making all management

decisions and in fact made such decisions during the years in issue.9 We conclude

that petitioners satisfied the active participation standard in 2007 and 2008, and thus

are entitled to deduct a portion of the losses from their rental real estate activities

pursuant to section 469(i) subject, however, to the phaseout calculation under

section 469(i)(3). We leave for the parties to determine, as part of their computation

under Rule 155, the amount of loss, if any, petitioners are entitled to deduct after the

phaseout calculation is made with respect to each year in issue.

C. Penalties

      Respondent contends that petitioners are liable for the accuracy-related

penalty under section 6662(a) and (b)(2) for a substantial understatement of income

tax with respect to the years in issue.




      9
          Petitioners arranged for others to provide services with respect to their
rental properties such as showing the properties, collecting rent, and making repairs,
but petitioners themselves were always responsible for approving repair
expenditures, deciding on rental terms, and approving new tenants.
                                        - 14 -

      Section 6662(a) and (b)(2) imposes a penalty equal to 20% of the amount of

any underpayment that is due to a substantial understatement of income tax. An

individual substantially understates his or her income tax when the reported tax is

understated by the greater of 10% of the tax required to be shown on the return or

$5,000. Sec. 6662(d)(1)(A).

      The accuracy-related penalty does not apply to any portion of an

underpayment, however, if it is shown that there was reasonable cause for the

taxpayer’s position and that the taxpayer acted in good faith with respect to that

portion. Sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. The determination of

whether the taxpayer acted with reasonable cause and in good faith is made on a

case-by-case basis, taking into account the pertinent facts and circumstances. Sec.

1.6664-4(b)(1), Income Tax Regs.

      With respect to a taxpayer’s liability for any penalty, section 7491(c) places

on the Commissioner the burden of production, thereby requiring the Commissioner

to come forward with sufficient evidence indicating that it is appropriate to impose

the penalty. Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). Once the

Commissioner meets his burden of production, the taxpayer must come forward

with persuasive evidence that the Commissioner’s determination is incorrect. See

Rule 142(a); Welch v. Helvering, 290 U.S. at 115.
                                         - 15 -

      Respondent has satisfied his burden of production because the record

demonstrates the presence of a substantial understatement of income tax attributable

to, inter alia, the disallowed deductions conceded by petitioners. See supra note 2.

Accordingly, petitioners bear the burden of proving that the accuracy-related penalty

should not be imposed with respect to any portion of the underpayment for which

they acted with reasonable cause and in good faith. See sec. 6664(c)(1); Higbee v.

Commissioner, 116 T.C. at 446.

      Petitioners have furnished no evidence or testimony to carry their burden with

respect to any of the items conceded in the stipulation of settled issues. See supra

note 2. Consequently, we hold that petitioners are liable for the accuracy-related

penalty applicable to the conceded items.

      We are convinced, however, that petitioners had reasonable cause to believe

that Mrs. Manalo qualified as a real estate professional and materially participated

in petitioners’ rental real estate activities. It is clear that Mrs. Manalo devoted a

great deal of time to her business as a real estate broker and made management

decisions in connection with petitioners’ rental activities. Petitioners provided

calendars that were generally credible and prepared contemporaneously with the

appointments noted therein. Moreover, petitioners provided credible testimony at

trial regarding their rental real estate activities and much of that testimony was
                                         - 16 -

corroborated, not only through documentary evidence, but also by the testimony of

respondent’s witnesses. Petitioners, however, simply failed to meet their burden of

proof. Therefore, we decline to sustain the accuracy-related penalty with respect to

those portions of the underpayments attributable to petitioners’ rental real estate

losses claimed on Schedules E for the years in issue.

                                      Conclusion

      We have considered all of the arguments advanced by the parties, and, to the

extent not addressed herein, we conclude that those arguments irrelevant, moot, or

meritless.

      To give effect to the foregoing,


                                                  Decision will be entered

                                         under Rule 155.
