                      123 T.C. No. 16



                UNITED STATES TAX COURT



  TONY R. CARLOS AND JUDITH D. CARLOS, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 5512-03.             Filed September 20, 2004.



     Ps owned and actively engaged in the conduct of
two S corporations, B and J. B rented real property BB
from Ps, and J rented real property JJ from Ps. Ps
grouped the two rentals together to make up a single
passive “activity” for purposes of sec. 469, I.R.C. B
paid its rent on BB according to its lease with Ps,
resulting in income to Ps. J did not pay its rent on
JJ under its lease with Ps, resulting in a loss to Ps.
Ps netted the income and loss from the two rentals,
claiming nonpassive net rental income. R, however,
determined that the income and loss items could not be
netted, that the income from renting BB was nonpassive
and the loss from renting JJ was passive, and that Ps
could not offset the nonpassive BB income with the
passive JJ loss.


     Held: Sec. 1.469-2(f)(6), Income Tax Regs.,
recharacterizes rental income from the taxpayer’s
active business as nonpassive, thereby removing such
                                - 2 -

     income from   the calculation of passive loss for a sec.
     469, I.R.C.   activity, despite the proper grouping of
     such income   with an item of passive loss against which
     such income   would otherwise be offset.



     Murray H. Falk, for petitioners.

     Paul L. Dixon, for respondent.



                               OPINION


     WELLS, Judge:    Respondent determined deficiencies in

petitioners’ Federal income taxes for 1999 and 2000 as follows:1

                   Year                 Deficiency

                   1999                  $17,011
                                          1
                   2000                     14,443
     1
      Although respondent initially determined corresponding
deficiencies of $17,011 and $16,384 for 1999 and 2000,
respectively, the parties have stipulated that the deficiency
determined by respondent for 2000 is $14,443.

     The issue to be decided is whether losses from petitioners’

rental activity constitute passive activity losses pursuant to

section 469.2




     1
      Although respondent initially determined sec. 6662(a)
accuracy-related penalties of $3,402.20 for 1999 and $3,276.80
for 2000, respondent concedes that penalties are inapplicable.
     2
      All section references are to the Internal Revenue Code, as
amended, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
                                - 3 -

                              Background

     The parties have submitted the instant case fully

stipulated, without trial, pursuant to Rule 122.     The parties’

stipulations of fact are incorporated herein by reference and are

found as facts in the instant case.

     Petitioners are husband and wife.     At the time of filing

their petition, petitioners resided in Apple Valley, California.

     During the years in issue, petitioners owned two commercial

real estate properties in Apple Valley, California.     One property

was located at 22040 Bear Valley Road (Bear Valley Road

property), and the other was located at 13685/13663 John Glenn

Road (John Glenn Road property).    Collectively, the Bear Valley

Road property and the John Glenn Road property are referred to as

the rental properties.   Petitioners also owned all of the stock

of two S corporations—-Bear Valley Fabricators & Steel Supply,

Inc. (steel company), and J&T’s Branding Company, Inc.

(restaurant).

     During 1999 and 2000, petitioners leased the Bear Valley

Road property to the steel company and leased the John Glenn Road

property to the restaurant.

     The steel company agreed to pay rent of $120,000 per year to

petitioners for the Bear Valley Road property.     The steel company

paid the rent, which, after taxes, depreciation, and bank

charges, resulted in net rental income to petitioners for the
                               - 4 -

Bear Valley Road property of $102,646 in 1999 and $102,045 for

2000.

     The restaurant agreed to pay rent of $60,000 per year to

petitioners for the John Glenn Road property.   The restaurant

failed to pay its designated rent in 1999 and 2000, which, after

mortgage interest, taxes, depreciation, and amortization incurred

by petitioners, resulted in a net loss to petitioners for the

John Glenn Road property of $41,706 in 1999 and $40,169 in 2000.

     Petitioners grouped the rental properties together to

constitute a single “activity”.   On Schedules E, Supplemental

Income and Loss, of their 1999 and 2000 income tax returns,

petitioners netted the income from the Bear Valley Road property

and the loss from the John Glenn Road property.   For 1999,

petitioners subtracted the $41,706 net loss on the John Glenn

road property from the $102,646 net income on the Bear Valley

Road property, resulting in net rental income of $60,940.

Similarly, for 2000, petitioners subtracted the $40,169 net loss

on the John Glenn Road property from the $102,045 net income on

the Bear Valley Road property, resulting in net rental income of

$61,876.   Petitioners reported the net rental income as not from

a passive activity and reported no passive activity loss.

     Respondent disallowed petitioners’ net losses on the John

Glenn Road property under section 469(a) as passive activity

losses.
                                 - 5 -

                              Discussion

     Section 469(a) disallows the passive activity loss of an

individual taxpayer.3    The Internal Revenue Code defines “passive

activity” as an activity involving the conduct of a trade or

business in which the taxpayer does not materially participate.4



     3
      SEC. 469.    PASSIVE ACTIVITY LOSSES AND CREDITS LIMITED.

          (a) Disallowance.--

               (1) In general.--If for any taxable year the
          taxpayer is described in paragraph (2), neither–-

                       (A) the passive activity loss, nor

                       (B) the passive activity credit,

          for the taxable year shall be allowed.

               (2) Persons described.-- The following are
          described in this paragraph:

                       (A) any individual, estate, or trust, * * *.

     4
          SEC. 469(c).    Passive Activity Defined.--For purposes
     of this section–-

               (1) In general.--The term “passive activity” means
          any activity--

                       (A) which involves the conduct of any trade
                  or business, and

                       (B) in which the taxpayer does not materially
                  participate.

               (2) Passive activity includes any rental activity.
          * * * the term “passive activity” includes any
          rental activity.
                               - 6 -

“Passive activity”, however, generally includes any rental

activity, regardless of material participation.   Sec. 469(c)(2).

     Section 469 does not define “activity”.   See Schwalbach v.

Commissioner, 111 T.C. 215, 223 (1998).   The Secretary, however,

has prescribed regulations pursuant to section 469(l) that

specify what constitutes an “activity”.   Section 1.469-4(c),

Income Tax Regs., sets forth rules for grouping tax items

together to determine what constitutes a single “activity”.     That

regulation provides:   “One or more trade or business activities

or rental activities may be treated as a single activity if the

activities constitute an appropriate economic unit for the

measurement of gain or loss for purposes of section 469.”    Sec.

1.469-4(c)(1), Income Tax Regs.   Whether activities constitute an

“appropriate economic unit” depends on the facts and

circumstances.5

     Respondent concedes that petitioners’ grouping of the Bear

Valley Road property and the John Glenn Road property is an

appropriate economic unit.   The parties, however, dispute the




     5
      Sec. 1.469-4(c)(2), Income Tax Regs., provides:

          (2) Facts and circumstances test. Except as
     otherwise provided in this section, whether activities
     constitute an appropriate economic unit and, therefore,
     may be treated as a single activity depends upon all
     the relevant facts and circumstances. A taxpayer may
     use any reasonable method of applying the relevant
     facts and circumstances in grouping activities * * *.
                               - 7 -

method for computing passive activity loss within the “activity”

grouping.

     Section 469(d)(1) defines “passive activity loss” as “the

amount (if any) by which–-(A) the aggregate losses from all

passive activities for the taxable year, exceed (B) the aggregate

income from all passive activities for such year.”   Passive

activity loss is computed by first netting items of income and

loss within each passive activity and then subtracting aggregate

income from all passive activities from aggregate losses.   See

id.; sec. 1.469-2T, Temporary Income Tax Regs., 53 Fed. Reg. 5686

(Feb. 25, 1988).

     In carrying out the provisions of section 469, section

469(l)(2) authorizes the Secretary to promulgate regulations

“which provide that certain items of gross income will not be

taken into account in determining income or loss from any

activity (and the treatment of expenses allocable to such

income)”.   While the general rule of section 469(c)(2)

characterizes all rental activity as passive, section 1.469-

2(f)(6), Income Tax Regs., requires net rental income received by

the taxpayer for use of an item of the taxpayer’s property in a

business in which the taxpayer materially participates to be

treated as income not from a passive activity (sometimes referred
                                - 8 -

to as the self-rental rule or the recharacterization rule),6 and

provides:

          (f)(6) Property rented to a nonpassive activity.
     An amount of the taxpayer’s gross rental activity
     income for the taxable year from an item of property
     equal to the net rental activity income for the year
     from that item of property is treated as not from a
     passive activity if the property–-

            (i) Is rented for use in a trade or business
            activity * * * in which the taxpayer materially
            participates * * *.[7]

     Petitioners concede that they “materially participated” in

the conduct of both the steel company and the restaurant during

1999 and 2000, and they do not contend that section 1.469-

2(f)(6), Income Tax Regs., is either invalid or inapplicable.

Petitioners, however, contend that computation of passive

activity loss requires the netting of income and loss from all

items of rental property grouped within the section 469 passive

activity and that only after such a computation does section


     6
      To illustrate the self-rental rule, suppose taxpayer A owns
a property and all outstanding stock of B Corp. A materially
participates in the operations of B Corp., which generates $100
of income and has $50 of operating expenses in year 1. In year
1, A enters a lease agreement with B Corp. requiring B Corp. to
pay $50 of annual rent to A for A’s property. B Corp. uses the
property in year 1 as its headquarters. If B Corp. were to pay
its $50 net income to A in the form of salary, A would have $50
of income not from a passive activity. However, because the $50
of net income is paid to A in the form of rent, it is per se
passive income pursuant to sec. 469(c)(2). Sec. 1.469-2(f)(6),
Income Tax Regs., recharacterizes the $50 of net rental income as
not from a passive activity.
     7
      As discussed below, sec. 1.469-2(f)(6), Income Tax Regs.,
is authorized by sec. 469(l)(2).
                                 - 9 -

1.469-2(f)(6), Income Tax Regs., apply to recharacterize passive

income as nonpassive.     Respondent contends that section 1.469-

2(f)(6), Income Tax Regs., requires the removal of self-rental

income from the passive activity loss computation and that, after

income from the Bear Valley Road property is properly removed

from the passive activity loss computation, petitioners are left

with no passive income to offset against the passive loss on the

John Glenn Road property.     We conclude that section 469(d) and

the legislative regulations of section 1.469-2(f)(6), Income Tax

Regs., support respondent’s position.

     Section 469(l)(2) explicitly authorizes the promulgation of

regulations to remove certain items of gross income from the

calculation of income or loss from any activity.     Section 1.469-

2(f)(6), Income Tax Regs., is a legislative regulation and is

entitled to appropriate deference from this Court.     See Chevron

U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837

(1984).   In Chevron, the U.S. Supreme Court stated:    “Such

legislative regulations are given controlling weight unless they

are arbitrary, capricious, or manifestly contrary to the

statute.”   Id. at 844.    We have previously held that section

1.469-2(f)(6), Income Tax Regs., is not arbitrary, capricious, or

manifestly contrary to section 469(l)(2).     Krukowski v.

Commissioner, 114 T.C. 366 (2000), affd. 279 F.3d 547 (7th Cir.

2002); Shaw v. Commissioner, T.C. Memo. 2002-35; Sidell v.
                              - 10 -

Commissioner, T.C. Memo. 1999-301, affd. 225 F.3d 103 (1st Cir.

2000).   The Courts of Appeals for the First, Fifth, and Seventh

Circuits have also upheld the validity of section 1.469-2(f)(6),

Income Tax Regs.   See Krukowski v. Commissioner, 279 F.3d 547

(7th Cir. 2002); Sidell v. Commissioner, 225 F.3d 103 (1st Cir.

2000); Fransen v. United States, 191 F.3d 599 (5th Cir. 1999).

     Section 1.469-2(f)(6), Income Tax Regs., explicitly

recharacterizes net rental activity income from an “item of

property” rather than net income from the entire rental

“activity”.   Both section 469 and the regulations thereunder

clearly distinguish between net income from an “item of property”

and net income from the entire “activity”,8 which might include

rental income from multiple items of property.9   Under the

authority of section 469(l)(2), the Secretary could have



     8
      Sec. 469(l)(2) authorizes the implementation of regulations
to remove “certain items of gross income” from the determination
of income from an “activity”. The designation of an “[item] of
gross income” to be removed from such a determination is narrower
than and distinct from the term “activity” income (from which the
item must be removed). Since sec. 1.469-2(f)(6), Income Tax
Regs., designates “net rental activity income for the year from
* * * [an] item of property” as the item of gross income to be
removed pursuant to sec. 469(l)(2) from the determination of
income from the “activity”, net rental activity income from an
“item” of property is also narrower than and distinct from the
broader term “activity” income.
     9
      The fact that multiple rentals may be grouped together
pursuant to sec. 1.469-4(c), Income Tax Regs., to make up a
single “activity” further evidences the distinction between net
income from an “item” of property and net income from the entire
“activity”.
                               - 11 -

implemented regulations to remove items of gross income equal to

net income from the entire activity, but the Secretary instead

implemented regulations to recharacterize net income from a

specific item of self-rental property.      The use of the term “item

of property” leads us to conclude that respondent’s

interpretation of the regulation is correct.     Accordingly, in the

instant case, self-rental income from the Bear Valley Road

property is removed from the passive activity loss computation,

leaving no passive income to be offset by the passive loss on the

John Glenn Road property.

     Section 469(d)(1) defines passive activity loss as the

excess of losses from passive activities over income from passive

activities.    Consequently, recharacterization of “self-rental

income” under section 1.469-2(f)(6), Income Tax Regs., as not

from a passive activity effectively removes the income from the

passive activity loss computation.      Removal of a single item of

income from such computation does not affect the passive

characterization of items remaining within the activity.      See

Shaw v. Commissioner, supra.    “Under the self-rented property

rule, the net rental income from self-rented property is treated

as nonpassive income and the net rental losses are treated as

passive losses, even though the rental activities are passive

activities.”    Id.
                               - 12 -

     Although we have not previously decided whether grouping

items of passive income and loss within a single section 469

activity precludes recharacterization under section 1.469-

2(f)(6), Income Tax Regs., of income that would otherwise offset

the passive loss,10 we have consistently upheld

recharacterization of passive income which would otherwise offset

passive loss without considering the effect of the activity

grouping.   See, e.g., Krukowski v. Commissioner, 114 T.C. 355

(2000); Schwalbach v. Commissioner, 111 T.C. 215, 219-224 (1998);

Cal Interiors, Inc. v. Commissioner, T.C. Memo. 2004-99; Shaw v.

Commissioner, supra; Sidell v. Commissioner, T.C. Memo. 1999-301;

Connor v. Commissioner, T.C. Memo. 1999-185, affd. 218 F.3d 733

(7th Cir. 2000).11   In each of these cases, we validated


     10
      In Krukowski v. Commissioner, 279 F.3d 547, 554 (7th Cir.
2002), affg. 114 T.C. 366 (2000), the taxpayers raised the single
activity grouping argument on appeal, but the Court of Appeals
did not address the issue because the taxpayers had not elected
to treat the rental activities as a single activity on their
return. The taxpayers in Shaw v. Commissioner, T.C. Memo. 2002-
35, likewise, belatedly tried to raise the issue of single
activity grouping but were not allowed to do so.

     11
      In Fransen v. United States, 82 AFTR 2d 6621, 98-2 USTC
par. 50,776 (E.D. La. 1998), affd. 191 F.3d 599 (5th Cir. 1999),
the taxpayers similarly challenged application of sec. 1.469-
2(f)(6), Income Tax Regs., in an action for refund. The
taxpayers argued that sec. 1.469-2(f)(6), Income Tax Regs., is
invalid because it contradicts the statutory designation of
rental activity income as passive. The court awarded summary
judgment to the Commissioner, holding that sec. 1.469-2(f)(6),
Income Tax Regs., is consistent with the express congressional
purposes of sec. 469 and the authorizing language of sec.
                                                   (continued...)
                                - 13 -

application of section 1.469-2(f)(6), Income Tax Regs., to

recharacterize specific items of income, leaving remaining items

of passive loss with no offset.

     In the instant case, we conclude that activity grouping does

not preempt the application of section 1.469-2(f)(6), Income Tax

Regs.     To hold otherwise would undermine the congressional

purpose for enacting section 469 and authorizing section 1.469-

2(f)(6), Income Tax Regs., to wit:       the prevention of sheltering

of nonpassive income with passive losses.      H. Conf. Rept. 99-841

(Vol. II), at II-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147.       The

conference report accompanying section 469 describes this

legislative purpose:

          Regulatory authority of Treasury in defining non-
     passive income.--The conferees believe that
     clarification is desirable regarding the regulatory
     authority provided to the Treasury with regard to the
     definition of income that is treated as portfolio
     income or as otherwise not arising from a passive
     activity. The conferees intend that this authority be
     exercised to protect the underlying purpose of the
     passive loss provision, i.e., preventing the sheltering
     of positive income sources through the use of tax
     losses derived from passive business activities.

          Examples where the exercise of such authority may
     (if the Secretary so determines) be appropriate include
     the following * * * (2) related party leases or sub-
     leases, with respect to property used in a business
     activity, that have the effect of reducing active
     business income and creating passive income * * *. [Id.]




     11
      (...continued)
469(l)(3).
                              - 14 -

The facts of the instant case appear to fall within the

description of activity that Congress intended to prevent.

     Petitioners’ interpretation of section 1.469-2(f)(6), Income

Tax Regs., would effectively allow a taxpayer to subvert

Congress’s intent.   Petitioners’ interpretation would allow a

taxpayer to convert nonpassive income into passive income against

which passive losses could be offset by manipulating the payment

of rent from a business controlled by the taxpayer on property

rented from the taxpayer to the controlled business.12    See Shaw

v. Commissioner, T.C. Memo. 2002-35.   By converting nonpassive

income into passive income in this manner, such a taxpayer would

be able to shelter otherwise nonpassive income with passive

losses.   Petitioners’ interpretation would allow petitioners to

shelter nonpassive income from the Bear Valley Road property with

passive loss from the John Glenn Road property, contrary to

congressional intent.13


     12
      Because sec. 1.469-2(f)(6), Income Tax Regs., would apply
to recharacterize self-rental income under petitioners’
interpretation only to the extent such income exceeds passive
losses within the activity grouping, only the excess would be
subject to recharacterization. An amount of passive income equal
to the amount of passive losses would retain its passive
character and, therefore, be sheltered by passive losses within
the grouping.
     13
      The result in this case might appear harsh, since, as
respondent’s brief recognizes, had the restaurant paid its rent
on the John Glenn Road property, petitioners could have properly
offset related expenses against that rental income. However, we
must base our decision on the facts of the instant case: the
                                                   (continued...)
                              - 15 -

     Accordingly, we hold that net rental income from the Bear

Valley Road property constitutes income not from a passive

activity.   Net rental loss from the John Glenn Road property,

however, retains its characterization as loss from passive

activity.   Consequently, the loss is properly disallowed under

section 469(a).14

     To reflect the foregoing,

                                      Decision with respect to the

                                 deficiencies will be entered for

                                 respondent; decision with respect

                                 to the accuracy-related penalties

                                 pursuant to section 6662(a) will be

                                 entered for petitioners.




     13
      (...continued)
restaurant did not pay its rent for the John Glenn Road property.
Moreover, sec. 469(b) tempers the harshness of disallowing such
passive activity losses by allowing them to be carried forward.
     14
      Petitioners contend that the issue raised by respondent as
to whether loss from the John Glenn Road rental should be
disallowed as a passive activity loss constitutes a “new matter”,
distinct from respondent’s original contention, set forth in the
statutory notice of deficiency, that net income from the Bear
Valley Road rental is recharacterized as nonpassive. We need not
address this issue, however, because we decide only a legal
issue, not a factual one, and the burden of proof therefore does
not affect our decision.
