                        T.C. Memo. 2011-219



                       UNITED STATES TAX COURT



              TOM AND NANCY MILLER, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 21655-09.               Filed September 8, 2011.



     Michael J. Low, for petitioners.

     John M. Wall, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     KROUPA, Judge:    Respondent determined deficiencies in

petitioners’ Federal income taxes of $28,357 and $50,036 for 2005

and 2006 (years at issue), respectively, and $5,671.40 and

$10,007.20 accuracy-related penalties under section 6662(a) for

those years.   With respect to 2005, petitioners dispute the

entire deficiency and penalty except for $8,998 of disallowed
                                - 2 -

interest expense and a $17,350 rental activity loss from a

property at Avenida Monteflora in Desert Hot Springs,

California.1    With respect to 2006, petitioners dispute the

entire deficiency and penalty except for an $18,596 rental

activity loss from the property at Avenida Monteflora.

     We are asked to decide two issues.      The first issue is

whether petitioners’ rental real estate losses for the years at

issue were passive activity losses subject to the limitation

under section 469(a).2    We hold that petitioners’ losses were not

passive activity losses for two of their rental properties but

were passive activity losses for the remaining four properties.

The second issue is whether petitioners are liable for the

accuracy-related penalty under section 6662(a).     We hold that

they are not.

                          FINDINGS OF FACT

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

The stipulations of facts and accompanying exhibits are




     1
      The parties stipulated that petitioners failed to report
$8,998 of interest income for 2005 and that they did not
materially participate in the rental real estate activity
reported for the property at Avenida Monteflora in Desert Hot
Springs, California during the years at issue.
     2
      All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
                               - 3 -

incorporated by this reference.   Petitioners resided in Petaluma,

California at the time they filed the petition.

     Tom Miller (Mr. Miller), the older child of German

immigrants, had an interest in building, drafting and

architecture growing up.   He pursued his interest in boats,

however, after his father met an instructor at the California

Maritime Academy.

     Mr. Miller graduated from the California Maritime Academy in

1980 with a bachelor of science degree in nautical industrial

technology.   He quickly left his first job, which required him to

spend months at sea, because it kept him away from Nancy Miller

(Mrs. Miller).3   He took a job with a tugboat company that

allowed him to be nearer to Mrs. Miller, who is now his wife of

27 years, and to return to the San Francisco Bay area.

Petitioners have two daughters.

     At the age of 29, Mr. Miller became a partner in the San

Francisco Bar Pilots Association (SFBPA) and began piloting

commercial seagoing vessels for SFBPA.4   During the years at

issue, Mr. Miller piloted client vessels for the SFBPA, including

large container ships, passenger cruise ships and large military



     3
      Mrs. Miller is a bookkeeper by training.
     4
      The SFBPA is a partnership for Federal income tax purposes.
During the years at issue, SFBPA was limited, by statute, to 60
pilots. All SFBPA pilots were equal partners of the SFBPA and
received equal distributions.
                               - 4 -

ships.   He piloted these client vessels from 13 miles at sea,

outside the San Francisco Bay Channel, throughout the San

Francisco, San Pablo and Suisun Bays, including the Sacramento

and San Joaquin Rivers.

     Mr. Miller’s schedule as an SFBPA pilot requires that he

work seven days and then have seven days off.    Mr. Miller

generally is not required to actually work for all of his seven

days “on.”   His schedule is also somewhat flexible and

predictable.   SFBPA pilots know roughly when they will have to

work during their “on” time and can trade turns in the pilot

rotation, subject to limitations.

     Despite his piloting work, Mr. Miller did not lose his

interest in building and drafting.     He acquired a class B general

contractor’s license in 1997, which he held during the years at

issue.   He provided construction services for clients in 2005,

including kitchen remodeling, replacing home siding, building

decks, building fences and replacing windows.    He also drafted

and worked on approximately a dozen building plans for houses,

including during the years at issue.

     Petitioners owned six rental real estate properties during

2005 and seven during 2006.   Petitioners conceded that they did

not materially participate in the rental real estate activity

with respect to a property at Avenida Monteflora, and therefore

the losses from that property are passive activity losses.
                               - 5 -

Petitioners argue, however, that the losses from their remaining

rental properties are not passive activity losses.

     For each of the rental properties at issue, petitioners

found tenants by placing ads and pictures on Craigslist.5    Mrs.

Miller prepared the written leases for the properties, which

petitioners both reviewed and signed.    Petitioners collected the

rents.   Petitioners also spent substantial time researching and

bidding on various rental real estate properties, including

during the years at issue.6   Mr. Miller created contemporaneous

timesheets, detailing time spent on his rental real estate

activities and construction business.7   The parties provided to




     5
      Craigslist is a network of online communities featuring
online classified advertisements for housing, jobs, goods,
services, romance, local activities, advice and more. Craigslist
sites, found at http://craigslist.org, serve hundreds of cities
across the United States and in dozens of countries, attracting
millions of visitors every month.
     6
      Mrs. Miller described some of the time-consuming process
and challenges of researching country homes. In addition to
online research, petitioners would travel to the locations,
research zoning laws and meet with the health inspector regarding
water wells and septic systems. On the basis of their research,
petitioners sometimes chose not to bid on the properties they
researched. When petitioners did make an offer, they did not
always acquire the property, for example when there was a higher
bidder.
     7
      As with his piloting logs, Mr. Miller did not record
administrative time spent on his rental real estate activities.
Mr. Miller’s real estate administrative work included planning
construction and repair jobs, amending timelines and ordering
materials.
                                - 6 -

the Court a number of other timesheets and summaries of

petitioners’ time allocation as well.8

     Petitioners’ first rental property was on Pepper Road in

Petaluma, California.   Petitioners bought five acres of land

surrounded by dairy ranches in 1990, and Mr. Miller built two

homes on the land.   Mrs. Miller assisted her husband with the

interior design of the homes.   Petitioners resided in one of the

homes and continued to reside in that home at the time of trial.

Petitioners leased the second home (Pepper Road property).   Mr.

Miller performs maintenance work for the Pepper Road property,

including maintenance of the well, septic system and all or most

of the yard.   Mr. Miller also performed repair work on the Pepper

Road property, including repairs to the fence, washing machine,

garbage disposal and back door.

     Petitioners and Martin Miller, Mr. Miller’s brother, owned

and leased a single-family home on Morning Glory Drive in

Petaluma, California from 2000 through the years at issue

(Morning Glory property).   Petitioners held an 85-percent

interest in the Morning Glory property until September 2006, when

they acquired Martin Miller’s 15 percent interest.   Martin Miller

resided next door to the Morning Glory property during the years



     8
      The Court notes that petitioners’ timesheets had some
inaccuracies and were imperfect. Nevertheless, the timesheets
provided useful guidance when coupled with petitioners’
testimony.
                                - 7 -

at issue.    He would occasionally mow the lawn at the Morning

Glory property, although the tenants would usually maintain the

property and mow the lawn.    Martin Miller had a new carpet

installed at the Morning Glory property in 2005.    Mr. Miller and

Martin Miller, along with an associate of Mr. Miller, installed a

fence on one side of the Morning Glory property in 2005.    Martin

Miller hired a fence company to build a fence on the other side

of the Morning Glory property in 2006, and Mr. Miller reimbursed

Martin Miller for some of the costs.

     Petitioners purchased a single-family home on Lind Avenue in

Clovis, California in June 2005 (Lind property).    The Lind

property is in a community governed by a homeowner’s association.

Homeowners in this community pay monthly homeowner’s association

fees for maintenance of common areas and mowing and maintenance

of the front yards of homes within the community.    Petitioners

rented the Lind property during the years at issue.

     Petitioners purchased a single-family home on N. Price

Avenue in Fresno, California in October 2005 (Price property).

Petitioners hired a landscaper to provide weekly mowing and

gardening services for the Price property for $65 per month.

Petitioners rented the Price property in 2006.

     Petitioners and Martin Miller purchased a single-family home

on E. Emerald Avenue in Fresno, California in June 2005 (Emerald

property).   Petitioners and Martin Miller held equal interests in
                                - 8 -

the Emerald property.    Petitioners hired and paid an individual

to provide bi-monthly mowing and gardening services for the

Emerald property.    Petitioners rented the Emerald property during

the years at issue.

     Petitioners purchased a single-family home on Bennett Valley

Road in Santa Rosa, California in October 2006 (Bennett Valley

property).   Mr. Miller and his subcontractor, Delmont Bogart (Mr.

Bogart), made a number of improvements to the Bennett Valley

property.    The improvements included building a retaining wall,

replacing decks, remodeling a bathroom, installing new gutters,

replacing the plumbing and repairing the furnace.    Mr. Bogart

described Mr. Miller as a workaholic who worked on the home after

his piloting job and performed manual labor alongside him for

each project on the property.    Petitioners leased the Bennett

Valley property.

     In addition to Mr. Bogart, other witnesses described Mr.

Miller’s work ethic as extraordinary.    A friend, pilot and

partner of Mr. Miller’s at SFBPA testified to his “one in a

million” work ethic, saying that he did not know anyone who

worked harder.    Mrs. Miller testified that she had to go to Mr.

Miller’s construction sites to see her husband.

     Mrs. Miller prepared petitioners’ joint returns for the

years at issue.    Petitioners did not make an election to treat
                                - 9 -

all their interests in rental real estate as one activity under

section 469(c)(7)(A) before or during the years at issue.

     Respondent issued the deficiency notice to petitioners,

disallowing the Schedule E rental real estate losses for the

years at issue and determining the deficiencies and accuracy-

related penalties for those years.      Petitioners timely filed a

petition.

                               OPINION

     We must decide whether a pilot of commercial seagoing

vessels spent more time on his construction and rental real

estate activities than on piloting, and whether he and his wife

materially participated in certain rental real estate activities

so that they may deduct rental real estate losses for the years

at issue.    We begin with the burden of proof.

     Determinations of the Commissioner in a deficiency notice

are presumed correct, and taxpayers bear the burden of proving

otherwise.    Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933).   Deductions are generally a matter of legislative grace,

and taxpayers bear the burden of proving entitlement to claimed

deductions.    INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440

(1934).   The burden to disprove a claimed deduction may shift to

the Commissioner if the taxpayers prove that they have satisfied

certain conditions.    Sec. 7491(a); Snyder v. Commissioner, T.C.
                                 - 10 -

Memo. 2001-255 (citing H. Conf. Rept. 105-599, at 240-241 (1998),

1998-3 C.B. 747, 994-995).   Petitioners have neither claimed nor

shown that they complied with the substantiation requirements of

section 7491(a).   The burden of proof, therefore, remains on

petitioners.   See Rule 142(a).

     Petitioners claimed losses of $71,464 and $143,091 from

their rental real estate activities for the years at issue.       The

deduction of passive activity losses is generally suspended.

Sec. 469(a).   A passive activity loss is the excess of the

aggregate losses from all passive activities for the taxable year

over the aggregate income from all passive activities.     Sec.

469(d)(1).   A passive activity includes the conduct of any trade

or business in which the taxpayer does not materially

participate.   Sec. 469(c)(1).    A rental activity generally is

treated as a per se passive activity.     Sec. 469(c)(2), (4).

     A taxpayer may, however, avoid having his or her real estate

activity classified as a per se passive activity if the taxpayer

is a qualifying real estate professional and satisfies the

material participation requirements of section 469(c)(1).     A

taxpayer will qualify as a real estate professional if: (i) more

than one-half of the personal services performed in trades or

businesses by the taxpayer during the taxable year are performed

in real property trades or businesses in which the taxpayer

materially participates, and (ii) such taxpayer performs more
                               - 11 -

than 750 hours of service during the taxable year in real

property trades or businesses in which the taxpayer materially

participates.   Sec. 469(c)(7)(B).

     A taxpayer may establish his or her 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).      This Court

has acknowledged that “reasonable means” is interpreted broadly

and that the temporary regulations may not provide precise

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

Nevertheless, a postevent “ballpark guesstimate” will not

suffice.    See Lee v. Commissioner, T.C. Memo. 2006-193; Goshorn

v. Commissioner, supra.

     Where, as here, a joint return has been made, the foregoing

real estate professional requirements are satisfied if either

spouse separately satisfies those requirements.    Sec.

469(c)(7)(B).   Thus, if Mr. Miller meets the foregoing

requirements, petitioners’ rental activities are not per se

passive and the normal passive activity loss rules of section

469(c)(1) will apply.   We now consider whether Mr. Miller

qualifies as a real estate professional.

     On the basis of the record and testimony provided at trial,

we find that Mr. Miller has established that he spent more than

750 hours performing significant construction work as a

contractor and on his rental real estate activities.      We find
                              - 12 -

that Mr. Miller spent more time on his construction work and

rental properties than he did piloting vessels in the years at

issue.

     Respondent highlights that Mr. Miller was a partner in the

SFBPA.   Respondent also notes that Mr. Miller occasionally spent

additional time on SFBPA-related activities outside of piloting.

Nevertheless, we find petitioners’ testimony and evidence

compelling.   Mr. Miller completed a number of significant

construction projects, both as a contractor and as a landlord, in

the years at issue.   He also performed a number of additional

real estate tasks including researching properties, bidding on

properties, finding tenants, collecting rent and performing

maintenance work at rental properties.   Mr. Miller presented

contemporaneous work logs for his construction and rental

activities and provided compelling testimony and witnesses.

Thus, we find that Mr. Miller is a qualified real estate

professional within the meaning of section 469(c)(7)(B).

     Having found that Mr. Miller is a qualified real estate

professional, we now consider whether petitioners materially

participated in their rental activities.   For this purpose, each

interest in rental real estate is treated as a separate rental

real estate activity unless the qualifying taxpayer makes an

election to treat all interests as a single activity.   See sec.

469(c)(7)(A).   Petitioners did not make such an election.   Also
                                - 13 -

for this purpose, we must consider both spouses’ efforts.      Sec.

469(h)(5); sec. 1.469-9(c)(4), Income Tax Regs.    Thus, we

consider whether petitioners’ joint efforts amount to material

participation with respect to each rental real estate activity.

     Material participation is defined generally as regular,

continuous and substantial involvement in the business

operations.   Sec. 469(h)(1).   A taxpayer can establish material

participation by satisfying any one of the seven tests provided

in the regulations.   Sec. 1.469-5T(a), Temporary Income Tax

Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988); see Akers v.

Commissioner, T.C. Memo. 2010-85.    Two tests are particularly

relevant here.

     A taxpayer is treated as materially participating in an

activity if his or her participation in that activity during the

taxable year constitutes substantially all of the participation9

in the activity for that year.    Sec. 1.469-5T(a)(2), Temporary

Income Tax Regs., supra.   A taxpayer is also treated as having

materially participated if the taxpayer participates in the

activity for more than 100 hours during the taxable year and the

taxpayer’s participation in the activity for the taxable year is

not less than the participation of any other individual.      Sec.



     9
      “Participation” generally means any work done in an
activity by an individual who owns an interest in the activity.
Sec. 1.469-5(f)(1), Income Tax Regs.
                               - 14 -

1.469-5T(a)(3), Temporary Income Tax Regs, 53 Fed. Reg. 5726

(Feb. 25, 1988).

     We are satisfied that petitioners participated in the rental

real estate activities at the Pepper Road property and the

Bennett Valley property for over 100 hours per year for the

relevant years.10   We are also satisfied that their participation

was not less than the participation of any other individual for

those years.   It follows, and we hold, that petitioners

materially participated in the rental real estate activities at

the Pepper Road property and the Bennett Valley property in the

relevant years and the deductions attributable to those

activities are not subject to limitation under section 469.

     Petitioners have not shown, however, that they participated

in the rental real estate activities at the Morning Glory

property, the Lind property, the Price property or the Emerald

property for over 100 hours per year for the relevant years.

They also have not carried their burden of proving that their

participation in the rental real estate activities at each of

these four properties constitutes substantially all of the

participation for those properties in the years at issue.     We

particularly note Martin Miller’s participation at the Morning

Glory property, which is adjacent to his home.   We sustain



     10
      As aforementioned, petitioners did not own the Bennett
Valley property in 2005.
                               - 15 -

respondent’s disallowance of losses with respect to the real

estate activities at the Morning Glory property, the Lind

property, the Price property and the Emerald property for the

years at issue.

     We now address whether petitioners are liable for the

accuracy-related penalty for a substantial understatement of

income tax for each year at issue.      A taxpayer may be liable for

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

attributable to, among other things, a substantial understatement

of income tax.    Sec. 6662(a), (b)(2).   There is a substantial

understatement of income tax if the amount of the understatement

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

on the return, or $5,000.    Sec. 6662(d)(1)(A); sec. 1.6662-

4(b)(1), Income Tax Regs.    We find that respondent has met his

burden of production if Rule 155 computations show petitioners

have a substantial understatement of income tax.     See Higbee v.

Commissioner, 116 T.C. 438, 446 (2001); Jarman v. Commissioner,

T.C. Memo. 2010-285.

     A taxpayer is not liable for an accuracy-related penalty,

however, if the taxpayer acted with reasonable cause and in good

faith with respect to any portion of the underpayment.     Sec.

6664(c)(1).   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 all pertinent facts and circumstances
                               - 16 -

including the taxpayer’s efforts to assess his or her proper tax

liability.    Sec. 6664(c)(1); sec. 1.6664-4(b), 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.        Sec.

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

     Petitioners state in their petition that they acted with

reasonable cause and in good faith, and we so find.      Petitioners

prevailed on the threshold question of whether Mr. Miller

qualifies as a real estate professional.      They also prevailed on

the question of whether they materially participated with respect

to two of their rental properties.      As for the remaining

properties, petitioners provided evidence and gave credible

testimony but simply failed to meet their burden of proof.

Nevertheless, petitioners provided extensive records of their

rental real estate activities, including contemporaneous

timesheets.    We find that petitioners acted with reasonable cause

and in good faith in claiming rental real estate losses for the

years at issue.   Accordingly, we decline to impose a penalty upon

petitioners.

     We have considered all arguments made in reaching our

decision and, to the extent not mentioned, we conclude that they

are moot, irrelevant, or without merit.
                        - 17 -

To reflect the foregoing,


                                  Decision will be entered

                             under Rule 155.
