                        T.C. Memo. 2000-60



                      UNITED STATES TAX COURT



          ANTONIO & LUZVIMINDA PUNGOT, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 20036–97.                 Filed February 24, 2000.



     Richard J. Sapinski, for petitioners.

     Robert F. Saal and Guy G. Lavignera, for respondent.



                        MEMORANDUM OPINION


     FAY, Judge:   Respondent determined deficiencies of $10,756

and $10,974 in petitioners’ 1994 and 1995 Federal income taxes,

respectively.   After concessions, the issue for decision is

whether section 469(c)(7)(D)(ii)1 is unconstitutional.



     1
      All section references are to the Internal Revenue Code in
effect for 1994 and 1995, and all Rule references are to the Tax
Court Rules of Practice and Procedure, unless otherwise noted.
                               - 2 -

     This is a fully stipulated case that was submitted without a

trial under Rule 122.   We incorporate in this opinion the

parties’ stipulation of facts and the exhibits.   Petitioners, who

resided in West New York, New Jersey, when they petitioned the

Court, filed joint Federal income tax returns for 1994 and 1995.

All references to petitioner are to Antonio Pungot.

Background

     During the years in issue, petitioner worked full time as a

mechanical engineer for E.A. Sears Burrwood PLLC and LKU Group

Inc., engineering consulting firms specializing in real estate

development.   He also spent time; i.e., 990 hours in 1994 and

1,552 hours in 1995, performing on–site maintenance at two

residential rental properties that he and his wife owned.

Petitioners, whose modified adjusted gross income exceeded

$100,000, see sec. 469(i)(3)(E), deducted $27,958 and $38,759 for

losses relating to the rental activity on their 1994 and 1995

Federal income tax returns, respectively.   In the statutory

notice, respondent overstated the amount of losses petitioners

reported on Schedules E, Supplemental Income and Loss; respon-

dent, who concedes that the notice is incorrect, now disallows

$15,866 and $38,381 of petitioners’ claimed losses.   Petitioners

concede that, absent a ruling in their favor on the constitu-

tional issue, respondent’s recomputed deficiencies of $4,125 for

1994 and $10,583 for 1995 are correct.
                                - 3 -

Discussion

     Generally, individuals may not currently deduct losses from

passive activities, defined to include all rental activities and

any trade or business activity in which the taxpayer does not

materially participate.    See sec. 469(a), (c)(1), (2), (4).

Material participation is involvement on a regular, continuous,

and substantial basis.    See sec. 469(h); see also sec.

1.469–5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5686,

5725–5726 (Feb. 25, 1988).    These passive loss rules, enacted as

part of the Tax Reform Act of 1986, Pub. L. 99–514, sec. 501, 100

Stat. 2085, 2233, prohibit affected taxpayers from using deduc-

tions of a passive activity to shelter wages or other active

income.   See Staff of Joint Comm. on Taxation, General Explana-

tion of the Tax Reform Act of 1986, at 209–215 (J. Comm. Print

1987).

     Although all rental activities are passive, regardless of

the taxpayer’s level of participation, Congress created an

exception for post–1993 rental activities of certain real estate

professionals.   See sec. 469(c)(7).2   Under this provision, a

rental real estate activity is not per se passive if the taxpayer



     2
      Legislative relief is also available under sec. 469(i),
which permits a taxpayer who “actively participated” in rental
real estate activities to claim a maximum loss of $25,000
annually. Sec. 469(i)(1) and (2). This exception is phased out
for taxpayers with modified adjusted gross incomes between
$100,000 and $150,000. See sec. 469(i)(3)(A), (E).
                               - 4 -

meets two requirements:   (1) He performs more than half of his

personal services during the year in real property trades or

businesses in which he materially participates; and (2) he works

more than 750 hours a year in those real estate activities.     See

sec. 469(c)(7)(B).   Personal services means any work performed by

an individual in connection with a trade or business.   See sec.

1.469–9(b)(4), Income Tax Regs., T.D. 8645, 1996–1 C.B. 73, 76.

Services rendered by an employee, however, do not count as per-

formed in a real property trade or business unless the employee

is a 5-percent owner of the employer.3   See sec. 469(c)(7)(D)(ii)

(adopting the definition of a “5–percent owner” under sec.

416(i)(1)(B)).   A couple who files jointly qualifies for the

exception under section 469(c)(7) only if either spouse sepa-

rately satisfies both requirements.    See sec. 469(c)(7)(B) (flush

language).   In determining material participation, however, the

participation of both spouses is combined.   See sec. 469(h)(5).

     Respondent concedes that petitioner meets the second

requirement of section 469(c)(7)(B)(ii); i.e., the 750–hour rule.



     3
      A real property trade or business is defined broadly as
“any real property development, redevelopment, construction,
reconstruction, acquisition, conversion, rental, operation,
management, leasing, or brokerage trade or business.” Sec.
469(c)(7)(C).
     Under sec. 1.469–5(f)(1), Income Tax Regs., an employee who
owns an interest in an activity is treated as participating in
that activity without regard to the capacity in which he works.
See also sec. 1.469–5T(k), Example (2), Temporary Income Tax
Regs., 53 Fed. Reg. 5686, 5727 (Feb. 25, 1988).
                               - 5 -

Moreover, the parties stipulated that petitioner would have

satisfied the first requirement if he had owned more than 5

percent of the engineering consulting firms.   Petitioners’ only

claim is that section 469(c)(7)(D)(ii) is unconstitutional

because, by treating a nonowner employee differently than a

“5–percent owner”, the statute violates the Fifth Amendment’s

guaranty of equal protection under the laws.

     Generally, a statutory classification is valid if it is

rationally related to a legitimate government interest.     See

Regan v. Taxation With Representation, 461 U.S. 540, 547 (1983).

We would apply a higher standard of review if the statute

infringed fundamental rights or targeted a suspect class.     See,

e.g., id.; Harris v. McRae, 448 U.S. 297, 322 (1980).

     In taxation, more so than in some other fields, Congress has

broad classification powers.   See Regan v. Taxation With

Representation, supra; Lehnhausen v. Lake Shore Auto Parts Co.,

410 U.S. 356, 359 (1973); Steward Mach. Co. v. Davis, 301 U.S.

548, 584 (1937); Brushaber v. Union Pac. R.R., 240 U.S. 1, 25–26

(1916); Flint v. Stone Tracy Co., 220 U.S. 107, 158 (1911).       As

the Supreme Court emphatically noted in Madden v. Kentucky, 309

U.S. 83, 87–88 (1940):

     The broad discretion as to classification possessed by
     a legislature in the field of taxation has long been
     recognized. * * * the passage of time has only served
     to underscore the wisdom of that recognition of the
     large area of discretion which is needed by a legis-
     lature in formulating sound tax policies. * * * Since
                               - 6 -

     the members of a legislature necessarily enjoy a
     familiarity with local conditions which this Court
     cannot have, the presumption of constitutionality can
     be overcome only by the most explicit demonstration
     that a classification is a hostile and oppressive
     discrimination against particular persons and classes.
     The burden is on the one attacking the legislative
     arrangement to negative every conceivable basis which
     might support it. [Fn. ref. omitted.]

Thus, if plausible reasons exist for Congress’ decision to grant

deductions to some taxpayers while denying them to others, and

the means chosen is not so attenuated as to render the dis-

tinction arbitrary or capricious, then we uphold the law.

Indeed, the classification “will not be set aside if any state of

facts reasonably may be conceived to justify it.”   McGowan v.

Maryland, 366 U.S. 420, 426 (1961) (emphasis added); see also

Bryant v. Commissioner, 72 T.C. 757, 764 (1979).

     Respondent maintains, and we agree, that section

469(c)(7)(D)(ii) implements legitimate goals of ensuring that

only real estate professionals who have an entrepreneurial stake

in a real property business will qualify for relief under section

469(c)(7).   The legislative history supports this view.

     Congress enacted section 469 to foreclose tax shelters.     See

S. Rept. 99–313 (1986), 1986–3 C.B. (Vol. 3) 714.   The treatment

of all rental activities as passive, however, created problems

among real estate professionals.   A full-time real estate

developer, for example, could not use losses from one aspect of

his business; i.e., renting properties, to offset income from
                                - 7 -

another aspect of his business; i.e., developing real estate,

except to the extent of the $25,000 allowance described above,

see supra note 2.    By contrast, a taxpayer who materially

participated in any other trade or business could use losses

incurred in that business against active income.      To “alleviate

this unfairness,” Congress modified the passive loss rules by

adding section 469(c)(7), effective for tax years beginning after

December 31, 1993.    H. Rept. 103–111, at 614 (1993), 1993–3 C.B.

167, 190.4   Not wanting to overburden the real estate market,

Congress sought to exclude active participants of that industry

from the impact of section 469.    It recognized, however, that an


     4
      See also 103 Cong. Rec. 2361 (1993) (statement of Sen.
Boren):
     Real estate is a major section of the U.S. economy and
     is a principal asset of banks, insurance companies, and
     pension funds. * * * Therefore, it is clearly in the
     best interest of our Nation’s economy to have a
     fundamentally sound real estate market.
         *       *       *        *       *       *        *
          The passive loss rules * * * treat people in the
     rental real estate business differently than
     professionals in all other businesses. * * *
          This inequitable situation has had dramatic
     negative economic effects. It has exacerbated the
     crisis in our financial industry by discouraging real
     estate professionals from holding on to troubled
     properties, thereby discouraging workouts of distressed
     properties. In addition, the unfavorable treatment of
     losses from rental real estate has decreased the
     willingness of entrepreneurs to purchase property held
     by the Resolution Trust Corporation, thus increasing
     the long–term exposure to all taxpayers. Finally, the
     downward pressure on real property values has seriously
     eroded local property tax bases.
                              - 8 -

employee of a real estate business, acting in any capacity, might

try to deduct losses from a real estate tax shelter against his

wages;5 hence, it added the “5–percent owner” rule of section

469(c)(7)(D)(ii) to ensure that only individuals who are

substantial owners of real estate businesses will benefit from

the exception.

     We believe section 469(c)(7)(D)(ii) survives an equal

protection challenge, for Congress acted rationally in denying

relief to an employee of a real estate business who lacks an

ownership stake in that business.

     Petitioners argue that the statute is arbitrary because it

does not extend to independent contractors.   They claim that, had

petitioner been an independent contractor rather than an employee

of the engineering consulting firms, their rental real estate

losses would have been deductible against active income.   We

reject their argument, for it is well settled that rational basis

review “is not a license for courts to judge the wisdom, fair-

ness, or logic of legislative choices.”    FCC v. Beach Communica-

tions, Inc., 508 U.S. 307, 313 (1993); see also Nordlinger v.

Hahn, 505 U.S. 1, 10 (1992); United States R.R. Retirement Bd. v.

Fritz, 449 U.S. 166, 175 (1980).    To be sure, “a State does not



     5
      Consider, for example, a real estate lessor and full–time
bookkeeper of a construction company who treats the rental
activity as nonpassive because he counts his employee services as
performed in a real property trade or business.
                               - 9 -

violate * * * Equal Protection * * * merely because the classifi-

cations made by its laws are imperfect.”     Dandridge v. Williams,

397 U.S. 471, 485 (1970).

     The question is simply whether the classification is

rationally related to a legitimate legislative goal.     Granting

relief to bona fide real estate professionals reflects such a

goal; appropriately, Congress considered factors which tend to

show active involvement in that industry, such as being an

owner–employee of a real estate business.

     In light of Congress’ broad latitude as to classifications

in tax statutes, we conclude that section 469(c)(7)(D)(ii) is

constitutionally valid, as it rationally serves a legitimate

public purpose.   To reflect concessions and our conclusion

herein,

                                            Decision will be entered

                                       under Rule 155.
