                          T.C. Summary Opinion 2016-12


                         UNITED STATES TAX COURT



      RODNEY J. GUARINO AND LAURAINE GUARINO, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 4776-13S.                          Filed March 14, 2016.



      Rodney J. Guarino and Lauraine Guarino, pro se.

      Lori Amadei and Jordan Musen, for respondent.



                              SUMMARY OPINION


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

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

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



      1
       Unless otherwise indicated, subsequent section references are to the
Internal Revenue Code of 1986, as amended, in effect for the years in issue. Rule
references are to the Tax Court Rules of Practice and Procedure.
                                           -2-

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

for any other case.

      In a notice of deficiency dated December 18, 2012 (notice), respondent

determined deficiencies in, and imposed section 6662(a) accuracy-related

penalties with respect to petitioners’ Federal income tax as follows:

                                                               Penalty
             Year                   Deficiency               sec. 6662(a)

             2008                    $26,404                  $5,280.80
             2009                     12,263                   2,452.60

      The issues for decision are whether: (1) income Rodney J. Guarino

(petitioner) received from Platt Properties (Platt) in 2008 constitutes net earnings

from self-employment subject to the section 1401 tax on self-employment income;

(2) petitioners are entitled to deductions for losses sustained in a rental real estate

activity; and (3) petitioners are liable for a section 6662(a) accuracy-related

penalty for either year in issue.

                                       Background

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

petition was filed, petitioners resided in California. At all times relevant here, they

have been married to each other.
                                        -3-

      Petitioner holds a bachelor of science degree in accounting and a master’s

degree in tax law. During each year in issue petitioner was licensed in California

as a real estate broker and was qualified to represent taxpayers before the Internal

Revenue Service (IRS) as an enrolled agent. He brokered real estate mortgages

and prepared Federal income tax returns as the sole proprietor of Westoaks

Financial (Westoaks).

      Through Westoaks petitioner originated and serviced residential and

commercial real estate loans in California. Westoaks accepted mortgage loan

applications from individuals and submitted the applications to various lenders.

Sometimes Westoaks serviced a mortgage loan on behalf of a lender after the

closing of the loan transaction.

      On March 13, 2008, petitioners purchased a house from William Lyon

Homes, Inc. (WLH), that they used as their residence (house). In connection with

this purchase, and as shown in the “Final Addendum to Joint Purchase Agreement

and Escrow Instructions”, WLH agreed to pay a $40,000 broker fee to Platt, which

is owned by petitioner’s brother-in-law. Platt remitted $39,000 of the fee to

petitioner in 2008. This payment is reported on a Form 1099-MISC,

Miscellaneous Income, that Platt issued to petitioner for that year.
                                        -4-

        Petitioners also owned a single-family house in Red Bluff, California (Red

Bluff property), that they held for rent and/or rented out in 2008 and 2009. In

2009 petitioners purchased a single-family house in Santa Clarita, California

(Santa Clarita property), which they held for rent and/or rented out during that

year.

        In 2008 petitioners hired a property management company to operate and

manage the Red Bluff property. Among other things, the property management

company was responsible for collecting rent from petitioners’ tenants. Otherwise,

as between petitioners, petitioner had more responsibility for the management of

the Red Bluff property and the Santa Clarita property (rental properties). From

time to time during each year in issue, he made repairs and renovations to the

rental properties, interviewed prospective tenants, and negotiated leases. If

supplies or building materials were needed in order to maintain the rental

properties, then petitioner routinely traveled to various locations to purchase those

supplies and/or materials. Mrs. Guarino and petitioners’ children were also

involved in the management and/or maintenance of the rental properties during the

years in issue, but we cannot tell with any degree of precision how much time each

of those individuals might have spent providing service in connection with the

rental properties or what services might have been provided. Neither petitioner
                                         -5-

kept a contemporaneous log or record that shows the amount of time either spent

or specific services either provided with respect to any specific rental property on

any specific date.

      During respondent’s examination of petitioners’ 2008 and 2009 Federal

income tax returns (returns)2 petitioner prepared a log (first log) of activities

related to the Red Bluff property. The first log identifies 10 dates on which

petitioner, Mrs. Guarino, or their children provided services related to the Red

Bluff property, but none of the entries identifies the amount of time spent. Two of

the entries relate to a year not before the Court.

      While the years here in dispute were under consideration by respondent’s

Appeals Office, petitioner prepared a second log (second log) of activities related

to the Red Bluff property. The second log includes activities on six dates, all in

2008. According to the second log, petitioners and/or their children spent a total

of 216 hours providing services to the Red Bluff property during 2008. No entry

in the log identifies who among petitioners and/or their children performed those

services.


      2
        Petitioners submitted an amended return for each year in issue. Because it
is not important to distinguish between the original return and the amended return
for either year in issue, references to a “return” in this opinion might relate to an
original return or an amended return, as appropriate.
                                        -6-

      After this case was commenced, petitioner prepared a third log (third log)

on which he reported activities related to: (1) the Red Bluff property and

Westoaks for each year in issue and (2) the Santa Clarita property for 2009. The

third log has numerous entries with respect to each rental property and includes

entries related to petitioner’s activities as the sole proprietor of Westoaks. Each

entry includes a date on which services were performed in connection with the

rental properties and/or Westoaks and the amount of time spent providing each

service. The entries associated with Westoaks all relate to petitioner. It is not

clear who performed the services shown in the portions of the logs dedicated to

the rental properties.

      Shortly before this case was called for trial, petitioner amended the third log

(amended third log) to correct discrepancies he discovered with respect to dates

and time spent on particular activities. The amended third log is similar but not

identical to the third log. According to the amended third log, in 2008: (1)

petitioner spent 882.5 hours providing mortgage brokerage services and (2)

petitioners and/or their children spent 129.5 hours providing services in

connection with the Red Bluff property. According to the amended third log, in

2009: (1) petitioner spent 752.6 hours providing mortgage brokerage services,
                                         -7-

(2) petitioner spent 47.95 hours providing leasing services, and (3) petitioners

and/or their children spent 233.25 hours on the rental properties.

      Petitioner prepared the returns. As relevant here, each return includes a

Schedule E, Supplemental Income and Loss, on which a loss deduction

attributable to the rental properties is claimed. Petitioners’ 2008 return also

includes a Schedule C, Profit or Loss From Business, for Westoaks. The income

reported on the Schedule C includes that payment that petitioner received from

Platt and a $39,000 deduction for “MISC REAL ESTATE FEES”.

      As relevant here, in the notice respondent: (1) disallowed the above-

referenced $39,000 deduction and increased petitioner’s section 1401 self-

employment tax accordingly; (2) disallowed the rental loss for each year in issue;

and (3) imposed a section 6662(a) accuracy-related penalty also for each year in

issue. Adjustments made in the notice that have been agreed to between the

parties or conceded or are computational will not be discussed.

                                     Discussion

I. Income From Platt

      Petitioners reported the income petitioner received from Platt and claimed a

deduction in the same amount on Westoaks’ Schedule C included with their 2008

return. Petitioners now concede that they are not entitled to that deduction. They
                                          -8-

now argue, however, that the income should not have been reported on the

Schedule C but is properly reported as “other income”, not attributable to a trade

or business. We agree.

      The $39,000 certainly was an accretion to petitioners’ wealth, see

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429 (1955), and is includable

in their income, but the income was received in connection with a personal

transaction, not in connection with the trade or business of either petitioner.

Because the income is not properly includable in the net profit from either of

petitioners’ trades or businesses, it does not fit within the definition of net

earnings from self-employment, see sec. 1402(a), and the income is not subject to

the section 1401(a) tax on self-employment income.

II. Rental Loss Deductions

      As we have observed in countless opinions, deductions are a matter of

legislative grace, and the taxpayer bears the burden of proof to establish

entitlement to any claimed deduction.3 Rule 142(a); INDOPCO, Inc. v.

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

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


      3
       Petitioners do not claim and the record does not demonstrate that the
provisions of sec. 7491(a) are applicable, and we proceed as though they are not.
                                          -9-

tax return must demonstrate that the deduction is allowable pursuant to some

statutory provision and must further substantiate that the expense to which the

deduction relates has been paid or incurred. See sec. 6001; Hradesky v.

Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir.

1976); sec. 1.6001-1(a), Income Tax Regs.

      According to respondent, the rental loss incurred for each year is deductible

only as allowable under section 469--a point petitioners do not dispute.4 In

general and as relevant here, that section provides that an individual is not entitled

to a deduction for a loss from a passive activity. See sec. 469(a), (d). Subject to

an exception set forth in the statute, by definition a rental activity, including a

rental real estate activity, is treated as a passive activity. See sec. 469(c)(2).

Section 469 is complex, and it is the topic of numerous opinions issued by this

Court. Because the parties agree on how section 469 works, however, we need not

delve into many of those complexities, and we focus only on the provisions of that

statute at the center of the parties’ dispute.

      According to petitioners, petitioner’s mortgage brokerage activity is a “real

property trade or business” within the meaning of section 469(c)(7)(C).

Petitioners go on to argue that because petitioner spent more than 750 hours

      4
          The amounts of the losses are not in dispute.
                                         - 10 -

providing services in connection with his mortgage brokerage business for both

years in issue, and because he spent more time in that business than he did in any

other trades for business during each of those years, for both years in issue he is a

taxpayer described in section 469(c)(7), which provides:

      (7) Special rules for taxpayers in real property business.

            (A) In general.--If this paragraph applies to any taxpayer for a
      taxable year--

                    (i) paragraph (2) shall not apply to any rental real
             estate activity of such taxpayer for such taxable year, and

                   (ii) this section shall be applied as if each interest of the
             taxpayer in rental real estate were a separate activity.

      Notwithstanding clause (ii), a taxpayer may elect to treat all interests
      in rental real estate as one activity. Nothing in the preceding
      provisions of this subparagraph shall be construed as affecting the
      determination of whether the taxpayer materially participates with
      respect to any interest in a limited partnership as a limited partner.

             (B) Taxpayers to whom paragraph applies.--This paragraph
      shall apply to a taxpayer for a taxable year 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.
                                         - 11 -

            In the case of a joint return, the requirements of the preceding
      sentence are satisfied if and only if either spouse separately satisfies
      such requirements. For purposes of the preceding sentence, activities
      in which a spouse materially participates shall be determined under
      subsection (h).

            (C) Real property trade or business.--For purposes of this
      paragraph, the term “real property trade or business” means any real
      property development, redevelopment, construction, reconstruction,
      acquisition, conversion, rental, operation, management, leasing, or
      brokerage trade or business.

      Taking section 469(c)(7) into account and given the manner in which

section 469 works, simply put, if petitioners are correct, then they are entitled to

the rental loss deductions here in dispute. Respondent, however, hardly agrees

that they are correct.

      According to respondent, because none of petitioners’ various logs is

reliable enough to establish the amount of time petitioner spent providing services

in any activity, there is no credible support in the record for a finding that

petitioner spent more than 750 hours in real property trades or businesses. In the

absence of such a finding, petitioners’ position, of course, must be rejected.

Perhaps more importantly, respondent disagrees that petitioner’s mortgage

brokerage business is a “real property trade or business”. Respondent argues that

mortgage brokerage services are in essence financing services. According to

respondent, financing services do not qualify as a real property trade or business
                                         - 12 -

within the meaning of section 469(c)(7)(C). Given the way section 469 works, if

respondent is correct on either point, then petitioners are not entitled to the rental

loss deductions as claimed on their returns.5

      Like respondent, we have concerns about the reliability of petitioners’ logs.

We need not address those concerns, however, because for the following reasons

we find that petitioner’s mortgage brokerage business is not a real property trade

or business within the meaning of section 469(c)(7)(C).

      Section 469(c)(7)(C) defines a real property trade or business to mean “any

real property development, redevelopment, construction, reconstruction,

acquisition, conversion, rental, operation, management, leasing, or brokerage trade

or business.” Petitioners focus on the word “brokerage” contained in that section

and argue that petitioner’s mortgage brokerage business is contemplated by the

statute. We disagree. Petitioners’ argument ignores the words “real property” that

precede the specific activities listed in the statute; those words modify each of

those activities. While petitioner’s mortgage brokerage activity constitutes a

“brokerage” trade or business, it does not constitute a “real property brokerage”

trade or business. Petitioner was not during either year in issue brokering real

      5
        Because of their adjusted gross income for each year in issue petitioners are
not otherwise entitled to a portion of the rental loss deduction allowable by sec.
469(i).
                                        - 13 -

estate; he was brokering financial services. The legislative history of the statute

supports the consequence of this distinction. Congress considered including

“financing operations” in the activities listed in section 469(c)(7)(C) but

specifically did not do so. See H.R. 2264, 103d Cong. (1993); H.R. 1414, 102d

Cong. (1991); S. 1257, 102d Cong. (1991); H.R. 3732, 101st Cong. (1989); S.

2384, 101st Cong. (1989); see also 138 Cong. Rec. H612-02 (Feb. 26, 1992).

      Because petitioner’s mortgage brokerage services relate to the origination

and servicing of residential and commercial real estate loans--financing

operations--we find that the hours petitioner performed with respect to that activity

are not included in the definition of a real property trade or business for purposes

of section 469(c)(7)(C). To the extent that some of the ancillary services

petitioner provided by and through Westoaks during the years in issue fall within

the definition of real property brokerage, he did not keep a sufficiently reliable

log showing how much of his time was dedicated to real property brokerage, and

we cannot otherwise make that determination from his testimony or any of the

other evidence admitted in this case.

      Assuming, without finding, that petitioner’s amended third log is accurate,

not treating the hours attributable to petitioner’s mortgage brokerage activities as

services provided in connection with a “real property trade or business” causes
                                         - 14 -

petitioner to fail both tests set forth in section 469(c)(7) for both years in issue.

Accordingly, petitioner is not a taxpayer described in section 469(c)(7) for either

of those years. It follows that the rental loss deductions here in dispute are subject

to the limitations imposed in section 469. Respondent’s determinations to that end

are sustained.

III. Accuracy-Related Penalty

        Section 6662(a) imposes a penalty of 20% of the portion of the

underpayment of tax attributable to, among other things, a substantial

understatement of income tax. Sec. 6662(b)(2). An understatement of income tax

is substantial within the meaning of section 6662 if, as relevant here, the

understatement exceeds $5,000. See sec. 6662(d); sec. 1.6662-4(b), Income Tax

Regs.

        Respondent bears the burden of production with respect to the imposition of

the penalty imposed in the notice and here in dispute, see sec. 7491(c), and that

burden has been satisfied because the understatement of income tax (here

computed in the same manner as the deficiency), will exceed $5,000 for each year

in issue, see secs. 6211, 6662(d)(2), 6664(a). That being so, it is petitioners’

burden to establish that the imposition of the penalty is not appropriate. See
                                       - 15 -

Higbee v. Commissioner, 116 T.C. 438, 447 (2001); see also Rule 142(a); Welch

v. Helvering, 290 U.S. 111, 115 (1933).

      Section 6664(c)(1) provides that the section 6662(a) accuracy-related

penalty does not apply to any portion of an underpayment 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 reasonable cause and in good

faith is made on a case-by-case basis, taking into account the pertinent facts and

circumstances. Id. para. (b)(1). Reliance upon the Commissioner’s publications

can protect a taxpayer against the imposition of a section 6662(a) accuracy-related

penalty. See Howard v. Commissioner, T.C. Memo. 2015-38.

       According to petitioners, they relied upon IRS Publication 551, Basis of

Assets, in concluding that they were entitled to the $39,000 deduction they now

concede. According to that publication, “rebates treated as adjustments to the

sales price” “reduce the basis of property”, which petitioners claim to have done

with respect to the house. Nonetheless, nothing in IRS Publication 551 provides

authority for the deduction of a rebate as a trade or business expense, nor did

petitioners actually receive a “rebate” on the purchase price of the house. Given

petitioner’s education and professional experience, petitioners’ reliance upon IRS
                                        - 16 -

Publication 551 in support of the deduction they now concede was not reasonable.

Furthermore, petitioners have not provided any explanation for the portions of the

underpayments of tax attributable to their other concessions. Accordingly, they

are liable for section 6662(a) accuracy-related penalties on the portions of the

underpayments of tax attributable to their concessions.

      The resolution of petitioners’ entitlement to the rental loss deductions is

made on technical grounds, i.e., whether mortgage brokerage constitutes real

property brokerage for purposes of section 469(c)(7). That being so, and although

we have rejected petitioners’ position that it does, we find that they acted

reasonably and in good faith in taking that position. It follows that for each year

in issue they are not liable for a section 6662(a) accuracy-related penalty with

respect to the portion of the underpayment of tax attributable to the disallowance

of the rental loss deduction.

      To reflect the foregoing,


                                                 Decision will be entered

                                       under Rule 155.
