                               T.C. Memo. 2014-95



                         UNITED STATES TAX COURT



     ALEXANDER HERWIG AND JENNIFER K. HERWIG, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 17682-11.                          Filed May 20, 2014.



      Thomas F. Hudgins, for petitioners.

      Anne M. Craig and Jeremy D. Cameron, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      GUY, Special Trial Judge: Respondent determined that petitioners are

liable for Federal income tax deficiencies and accuracy-related penalties for the

taxable years 2007, 2008, and 2009 (years in issue) as follows:
                                        -2-

[*2]
                                                     Penalty
                       Year     Deficiency         sec. 6662(a)

                       2007        $26,795            $5,359
                       2008         18,969             3,794
                       2009         30,362             6,072

Petitioners, husband and wife, filed a timely petition for redetermination with the

Court pursuant to section 6213(a).1 At the time the petition was filed, petitioners

resided in Florida.2




       1
       Unless otherwise indicated, section references are to the Internal Revenue
Code, as amended and in effect for the years in issue, and Rule references are to
the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
       2
       When the petition was filed, the Court inadvertently added the letter “S” to
the docket number designating this case as a small tax case despite petitioners’
request in the petition that the case not be processed under the Rules governing
small tax cases. See Rules 170-174. Upon discovering the error after trial, the
Court held a conference call with the parties, confirmed that petitioners did not
intend to elect small tax case status, and issued an order striking the letter “S”
from the docket number.
                                         -3-

[*3] After concessions,3 the issues for decision are whether petitioners:

(1) disposed of their interests in a passive activity during 2008 or 2010, thereby

allowing them to deduct what otherwise are suspended passive losses arising

during the years in issue, and (2) are liable for accuracy-related penalties for the

years in issue.

                               FINDINGS OF FACT

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

facts, the supplemental stipulation of facts, and the accompanying exhibits are

incorporated herein by this reference.




      3
        Petitioners concede that respondent correctly disallowed $34,121, $17,099,
and $12,964 of the losses they reported on Schedules E, Supplemental Income and
Loss, for 2007, 2008, and 2009, respectively. Respondent acknowledges that
petitioners may carry these passive losses forward to taxable year 2010.
Petitioners further concede that they are not entitled to the following deductions:
(1) other losses of $893,394 reported on Form 4797, Sales of Business Property,
for 2008; (2) net losses of $15,830, $18,140, and $1,981 reported on Schedules C,
Profit or Loss From Business, for 2007, 2008, and 2009, respectively; (3) real
estate taxes of $36,564 and interest of $20,485, reported on Schedules A, Itemized
Deductions, for 2007 and 2008, respectively; and (4) a loss of $768,208 identified
as “Other Write in Income” for 2009. The parties agree that (1) respondent
properly determined that a deduction for mortgage interest of $26,871 that
petitioners reported on Schedule A for 2007 is disallowed and that same item is
properly deductible on petitioners’ Schedule E for 2007, and (2) petitioners are
allowed deductions for taxes of $8,418 and $8,200 on Schedules E for 2007 and
2008, respectively.
                                         -4-

[*4] I. Via Capri and Via Murano Properties

      In March 2005 petitioners purchased a condominium unit at 2747 Via Capri,

Clearwater, Florida (Via Capri property), for $603,085. In April 2005 petitioners

purchased a second condominium unit (also in Clearwater) at 2729 Via Murano

(Via Murano property) for $492,280. Petitioners obtained mortgage loans from

Fifth Third Mortgage Co. (Fifth Third) to purchase the two properties. The Fifth

Third loan documents are not part of the record.

II. AJH Resources, LLC

      Petitioners each held a 49.5% interest in AJH Resources, LLC (AJH), from

2005 through at least 2010. Zander Solutions, Inc., held a 1% interest in AJH.4

During 2005 petitioners transferred ownership of the Via Capri and Via Murano

properties to AJH, which in turn acted as landlord and leased the two properties

from 2005 to 2008.

III. Foreclosure Action

      In 2008 Fifth Third filed a lawsuit against petitioners in the Circuit Court

for the Sixth Judicial Circuit in Pinellas County, Florida, to foreclose the

      4
       AJH is a limited liability company with at least two members. Because
AJH did not elect to be treated as a corporation, it is treated as a partnership (a so-
called passthrough entity) for Federal income tax purposes, and its profits and
losses “pass through” the entity to the owners, called members. Sec. 301.7701-
3(a) and (b)(1)(i), Proced. & Admin. Regs.
                                         -5-

[*5] mortgages on the Via Capri and Via Murano properties and to recover

deficiencies from them (foreclosure litigation). Petitioners filed a counterclaim

against Fifth Third.5

      The circuit court entered final judgments of foreclosure in favor of Fifth

Third in respect of both properties, and Fifth Third subsequently was the

successful bidder when the properties were sold at foreclosure sales on December

19, 2008. Fifth Third later filed a motion for entry of deficiency judgments

against petitioners in respect of both properties. As discussed below, Fifth Third’s

motion for entry of deficiency judgments and petitioners’ counterclaim remained

unresolved until they agreed to settle the foreclosure litigation in 2011.

      In the interim Fifth Third issued to Mr. Herwig Forms 1099-A, Acquisition

or Abandonment of Secured Property, for 2008 reporting that (1) the balance due

on the mortgage on the Via Capri property was $574,100 and the fair market value

of the property was $100,000, and (2) the balance due on the mortgage on the Via

Murano property was $471,100 and the fair market value of the property was

$102,000.




      5
       The record does not reflect the nature of petitioners’ cause of action against
Fifth Third.
                                         -6-

[*6] IV. AJH’s Tax Returns6

      The record includes Forms 1065, U.S. Return of Partnership Income, that

AJH filed for the taxable years 2008, 2009, and 2010.

      AJH reported an ordinary business loss of $1,800 on its Form 1065 for 2008

and attached to that return (1) a Schedule D, Capital Gains and Losses, reporting a

short-term capital loss of $7,216 and a long-term capital loss of $98,721,7 (2) a

Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S

Corporation, reporting a net rental real estate loss of $31,348 attributable to the

Via Capri and Via Murano properties, and (3) a Schedule L, Balance Sheets per

Books, reporting that it owned buildings and other depreciable assets with a value

of $1,045,100 at the end of the year.8 AJH issued Schedules K-1, Partner’s Share

of Income, Deductions, Credits, etc., to petitioners indicating that they each

contributed capital of $2,291 during 2008.


      6
       The parties stipulated that from 2005 to 2008 AJH claimed deductions for
depreciation on the Via Capri and Via Murano properties totaling $73,936 and
$60,668, respectively.
      7
       In addition to its rental real estate activity, AJH traded securities during the
years in issue.
      8
      Under the circumstances, we infer that this entry refers to the Via Capri and
Via Murano properties. There is no corresponding entry on the Schedule L,
however, for buildings and other depreciable assets owned at the beginning of
2008.
                                        -7-

[*7] AJH reported an ordinary business loss of $2,410 on its Form 1065 for 2009

and attached to that return (1) a Schedule D reporting a short-term capital loss of

$6,540, and (2) a Schedule L reporting that it owned buildings and other

depreciable assets with a value of $1,045,100 at the beginning of the year.9 AJH

issued Schedules K-1 to petitioners indicating that they each contributed capital of

$70,932 during 2009.

      AJH filed a Form 1065 for 2010 and checked a box on the form indicating

that it was a “Final return”. AJH reported that it had no receipts and no expenses

during 2010.

V. Petitioners’ Tax Returns

      Petitioners filed joint Forms 1040, U.S. Individual Income Tax Return, for

the years in issue. Petitioners attached Schedules E to their returns reporting in

relevant part “nonpassive” losses of $97,851, $33,608, and $2,386 for 2007, 2008,

and 2009, respectively, which they attributed to their interests in AJH. Petitioners

reported a loss of $893,394 on Form 4797 attached to their Form 1040 for 2008 in

connection with the Via Capri and Via Murano property foreclosures. Petitioners

carried over $768,208 of the loss described above to their Form 1040 for 2009.


      9
       There is no corresponding entry on the Schedule L for buildings and other
depreciable assets owned at the end of 2009.
                                        -8-

[*8] VI. Petitioners’ Settlement With Fifth Third

      In July 2011 petitioners executed a settlement agreement and release

(settlement agreement) with Fifth Third which states that, in consideration of Fifth

Third’s agreement to waive any deficiency judgments arising against petitioners in

respect of the Via Capri and Via Murano property foreclosures, petitioners agreed

to dismiss with prejudice the counterclaim that they had filed against Fifth Third.

VII. Notice of Deficiency

      Respondent determined in relevant part that deductions that petitioners

claimed for losses attributable to their interests in AJH were passive activity losses

within the meaning of section 469. Respondent further determined that, because

petitioners did not show that they had disposed of their “entire interest” in AJH

within the meaning of section 469(h), or that they had passive income during the

years in issue, the suspended losses were carried forward to the taxable year 2010.

VIII. Petition

      Petitioners filed a timely petition for redetermination. The petition alleges

that petitioners were “materially participating real estate professional[s]” during

the years in issue. As mentioned above, petitioners subsequently conceded that

respondent correctly determined that portions of the deductions that they claimed
                                            -9-

[*9] for losses attributable to their interests in AJH were passive activity losses

within the meaning of section 469.

IX. Developments at Trial

        Petitioners did not testify at trial, nor did they call any witnesses to testify.

The transcript of the proceedings is limited to counsels’ opening statements and

oral argument and the admission of an exhibit offered into evidence by petitioners’

counsel.

        Petitioners’ counsel began his presentation by informing the Court that

petitioners had recently discovered that they had never “deeded” the Via Capri and

Via Murano properties to AJH. He then made an oral motion to rescind a

statement in the parties’ stipulation of facts (executed two days earlier) that

petitioners had transferred the properties to AJH during 2005. The Court denied

petitioners’ counsel’s oral motion to rescind given that respondent would be

unduly prejudiced if petitioners were permitted to raise that issue for the first time

at trial.10

        10
        Petitioners did not raise any issue related to the transfer of the properties to
AJH in their petition or in an amended pleading, nor did they file a pretrial
memorandum raising the issue. We do not consider an issue that has not been
pleaded. See, e.g., Frentz v. Commissioner, 44 T.C. 485, 491 (1965), aff’d, 375
F.2d 662 (6th Cir. 1967). This is particularly true in a case like this where the
issue cannot be considered without surprise and prejudice to the opposing party.
                                                                          (continued...)
                                        - 10 -

[*10] The exhibit admitted into evidence at trial was a copy of petitioners’ July

2011 settlement agreement with Fifth Third. In the light of the settlement

agreement, the parties agreed that petitioners had cancellation of indebtedness

(COD) income in 2011 in connection with the Via Capri and Via Murano property

foreclosures (as opposed to 2008 as stated in the parties’ stipulation of facts).

      Petitioners’ counsel went on to state that, insofar as AJH had filed a Form

1065 for 2010, clearly marked “Final return”, it was petitioners’ position that they

should be deemed to have disposed of their entire interests in the passive activity

within the meaning of section 469(g) during 2010.

                                      OPINION

      As a general rule, the Commissioner’s determination of a taxpayer’s liability

in a notice of deficiency is presumed correct, and the taxpayer bears the burden of

proving that the determination is incorrect. Rule 142(a); Welch v. Helvering, 290

U.S. 111, 115 (1933). Petitioners do not contend that the burden of proof shifts to

respondent under section 7491(a). In any event, because we decide the question

whether petitioners disposed of their entire interests in the underlying passive

activity on the preponderance of the evidence, the allocation of the burden of


      10
       (...continued)
See Estate of Mandels v. Commissioner, 64 T.C. 61, 73 (1975).
                                        - 11 -

[*11] proof as to that issue is immaterial. See Knudsen v. Commissioner, 131

T.C. 185, 189 (2008).

      Deductions are a matter of legislative grace, and the taxpayer generally

bears the burden of proving entitlement to any deduction claimed. Rule 142(a);

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co.

v. Helvering, 292 U.S. 435, 440 (1934). A taxpayer claiming a deduction on a

Federal income tax return must demonstrate that the deduction is allowable

pursuant to a statutory provision and must further substantiate that the expense to

which the deduction relates has been paid or incurred. Sec. 6001; see Hradesky v.

Commissioner, 65 T.C. 87, 89-90 (1976), aff’d, 540 F.2d 821 (5th Cir. 1976).

I. Passive Activity Losses

      Taxpayers are allowed deductions for certain business and investment

expenses under sections 162 and 212. Section 469(a), however, generally

disallows passive activity losses and credits. A passive activity loss is defined as

the excess of the aggregate losses from all passive activities for a taxable year over

the aggregate income from all passive activities for that year. Sec. 469(d)(1).

With exceptions not relevant here, rental activities are passive activities. Sec.

469(c)(2).
                                         - 12 -

[*12] In accordance with section 469(b), a passive activity loss disallowed under

section 469 for any taxable year is carried forward and treated as a deduction

allocable to such activity in the next taxable year. If it turns out that the activity

results in additional passive activity losses in the carryover year (and in the

absence of passive income from some other activity), the suspended passive losses

are carried forward to the succeeding taxable year by application of section

469(b). See Langille v. Commissioner, T.C. Memo. 2010-49, aff’d, 447 Fed.

Appx. 130 (11th Cir. 2011). Suspended passive losses may be carried forward

indefinitely by this process until they are used. Id.

      Section 469(g) provides that passive losses that have been suspended as

described above are generally allowed when the taxpayer “disposes of his entire

interest in any passive activity”. See Bilthouse v. United States, 553 F.3d 513,

515 (7th Cir. 2009). More specifically, section 469(g)(1) provides that, if a

taxpayer disposes of his entire interest in a passive activity in a transaction with an

unrelated party where all of the gain or loss realized on the disposition of the

interest is recognized, the excess of any loss from such activity for the taxable year

(including suspended passive losses from an earlier taxable year), over any net

income or gain for such taxable year from all other passive activities (determined

after the application of subsection (b)), shall be treated as a loss which is not from
                                          - 13 -

[*13] a passive activity. See Lowe v. Commissioner, T.C. Memo. 2008-298. The

excess loss, if any, normally offsets the taxpayer’s income for the loss year, and

any remaining losses are carried back to the two preceding years and then carried

forward to the 20 years following the loss year in accordance with the provisions

of section 172.

      In the case of an S corporation, a partnership, or a grantor trust, the rules

prescribed in section 469(g) likewise apply when the entity disposes of its entire

interest in a passive activity. See S. Rept. No. 99-313, at 725 (1986), 1986-3 C.B.

(Vol. 3) 1, 725-726. If the entity carries on more than one activity, the entity’s

sale or exchange of all assets of a passive activity is sufficient to invoke the

provisions of section 469(g), even if other assets are retained. Id.11


      11
           In this regard, sec. 1.469-4(g), Income Tax Regs., provides as follows:

             (g) Treatment of partial dispositions.--A taxpayer may, for the
      taxable year in which there is a disposition of substantially all of an
      activity, treat the part disposed of as a separate activity, but only if the
      taxpayer can establish with reasonable certainty--

             (1) The amount of deductions and credits allocable to that part
      of the activity for the taxable year under § 1.469-1(f)(4) (relating to
      carryover of disallowed deductions and credits); and

            (2) The amount of gross income and of any other deductions
      and credits allocable to that part of the activity for the taxable year.
                                         - 14 -

[*14] Section 469(g) does not define or describe what constitutes a fully taxable

disposition, and there are no regulations elaborating on the principle. One

commentator has observed: “Section 469 is meant to curb artificial tax losses, not

on the ultimate deductibility of economic losses. When an investment in a passive

activity is sold and the cumulative result of the investment (including gain or loss

on sale) is a loss, the loss is an economic loss, not an artificial tax loss, and ought

to be allowed.” Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income,

Estates and Gifts, para. 28.10.1, at 28-95 to 28-96 (3d ed. 1999).

      Petitioners no longer dispute that the losses they claimed in connection with

AJH’s rental real estate activities were passive losses within the meaning of

section 469. Petitioners contend, however, that they disposed of their entire

interests in the passive activity when Fifth Third foreclosed on the properties in

December 2008 or, in the alternative, when AJH filed its “Final return” in 2010.12




      12
         Although the notice of deficiency upon which this case is based does not
concern the taxable year 2010, sec. 6214(b) provides in relevant part that, in
redetermining a deficiency for any taxable year, the Court shall consider such facts
with relation to the taxes for other years as may be necessary correctly to
redetermine the amount of such deficiency. Consistent with sec. 6214(b), the
Court has jurisdiction to consider petitioners’ claim that they may carry back
suspended passive losses from the taxable year 2010 to the taxable years in issue
(i.e., 2008 and 2009). See Calumet Indus., Inc. v. Commissioner, 95 T.C. 257,
274-276 (1990).
                                        - 15 -

[*15] We are not convinced, on this record, that petitioners satisfied the

requirements of section 469(g) when Fifth Third foreclosed on the Via Capri and

Via Murano properties in December 2008. As previously mentioned, section

469(g) contemplates that the taxpayer must dispose of his or her entire interest in a

passive activity in a transaction with an unrelated party under which all gain or

loss realized on such disposition is recognized.

      Section 1001 sets forth the rules governing the computation of gain or loss

realized from the sale or other disposition of property. A foreclosure sale

normally constitutes a disposition of property for purposes of section 1001(a). See

Helvering v. Hammel, 311 U.S. 504 (1941); Ryan v. Commissioner, T.C. Memo.

1988-12, aff’d sub nom. Lamm v. Commissioner, 873 F.2d 194 (8th Cir. 1989).

“A foreclosure action that is being appealed [, however,] is not ‘final’ in the

normal sense of that word.” See Great Plains Gasification Assocs. v.

Commissioner, T.C. Memo. 2006-276 (quoting Ryan v. Commissioner, T.C.

Memo. 1998-12).

      Although Fifth Third foreclosed on the properties in December 2008, we

note that AJH continued to list the properties as assets on Schedules L attached to

its Forms 1065 for 2008 and 2009. Petitioners offered no explanation why this

was the case if in fact the foreclosure sales were final in 2008. Moreover, Fifth
                                        - 16 -

[*16] Third’s motion for entry of deficiency judgments against petitioners and

petitioners’ counterclaim against Fifth Third were pending in the foreclosure

litigation until both matters were settled in July 2011. The parties agreed at trial

that, in the light of the Fifth Third settlement agreement, petitioners realized COD

income in 2011 (as opposed to 2008 as they initially assumed). Considering the

uncertainties inherent in the ongoing litigation, we conclude that the cumulative

economic effect of petitioners’ investment in the passive activity--a final

accounting of the gain or loss realized on the disposition of the passive activity

and recognition of any gain or loss for tax purposes--could not be determined in

2008. Consequently, petitioners did not dispose of their entire interests in the

passive activity within the meaning of section 469(g) as a result of the Fifth Third

foreclosure actions in December 2008, and their suspended passive losses were

not eligible to be treated as nonpassive losses for that year.

      We likewise agree with respondent that the tax return that AJH filed for

2010, marked “Final return”, does not demonstrate that petitioners disposed of

their entire interests in AJH within the meaning of section 469(g). Contrary to

petitioners’ position, a tax return alone is not proof of the statements contained

therein; a tax return merely sets forth the taxpayer’s claim. See Roberts v.

Commissioner, 62 T.C. 834, 837 (1974); Seaboard Commercial Corp. v.
                                        - 17 -

[*17] Commissioner, 28 T.C. 1034, 1051 (1957). Petitioners offered no testimony

themselves, and they did not call any witnesses to address the accuracy of AJH’s

Form 1065 for 2010. In the absence of any objective evidence that AJH wound up

its business and was no longer engaged in passive activities during 2010, we are

unable to conclude that petitioners disposed of their entire interests in the passive

activity in question within the meaning of section 469(g).

II. Accuracy-Related Penalty

      Section 6662(a) and (b)(1) imposes a penalty equal to 20% of the amount of

any underpayment attributable to negligence or disregard of rules or regulations.

The term “negligence” includes any failure to make a reasonable attempt to

comply with tax laws, and “disregard” includes any careless, reckless, or

intentional disregard of rules or regulations. Sec. 6662(c). Negligence also

includes any failure to keep adequate books and records or to substantiate items

properly. Sec. 1.6662-3(b)(1), Income Tax Regs.; see Olive v. Commissioner, 139

T.C. 19, 43 (2012).

      Section 6664(c)(1) provides an exception to the imposition of the accuracy-

related penalty if the taxpayer establishes that there was reasonable cause for, and

the taxpayer acted in good faith with respect to, the underpayment. Sec. 1.6664-

4(a), Income Tax Regs. The determination of whether the taxpayer acted with
                                          - 18 -

[*18] 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. Once the Commissioner meets his burden of

production, the taxpayer must come forward with persuasive evidence that the

Commissioner’s determination is incorrect. Higbee v. Commissioner, 116 T.C.

438, 447 (2001); see Rule 142(a); Welch v. Helvering, 290 U.S. at 115.

Respondent has discharged his burden of production under section 7491(c)

inasmuch as petitioners have conceded that they were not entitled to numerous

deductions for each of the years in issue. See sec. 1.6662-3(b)(1), Income Tax

Regs.

        Petitioners did not testify at trial, and they did not offer any other evidence

in support of the proposition that they had reasonable cause for, and they acted

in good faith with respect to, the underpayments for the years in issue. See sec.

1.6664-4(a), Income Tax Regs. Consequently, we sustain respondent’s
                                        - 19 -

[*19] determination that petitioners are liable for accuracy-related penalties under

section 6662(a) and (b)(1) for the years in issue.

      To reflect the foregoing,


                                                 Decision will be entered

                                       under Rule 155.
