                   T.C. Summary Opinion 2009-145



                      UNITED STATES TAX COURT



        NICHOLAS DAMER AND MARGARET FLYNN, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4138-08S.             Filed September 21, 2009.



     Nicholas Damer and Margaret Flynn, pro sese.

     John M. Wall, for respondent.



     DEAN, 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.   Pursuant to section 7463(b),

the decision to be entered is not reviewable by any other court,

and this opinion shall not be treated as precedent for any other

case.   Unless otherwise indicated, subsequent section references

are to the Internal Revenue Code in effect for the year in issue,
                                 - 2 -

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

     For 2005 respondent determined a $9,389 deficiency in

petitioners’ Federal income tax and a section 6662(a) accuracy-

related penalty of $1,878.     The issues remaining1 for decision

are whether petitioners are:     (1) Entitled to mortgage interest

deductions greater than the amounts respondent determined; (2)

entitled to deduct in 2005 a passive activity loss sustained in

2002; (3) subject to the passive activity loss limitations of

section 469; and (4) liable for a section 6662(a) accuracy-

related penalty.

                              Background

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

The stipulation of facts and the exhibits received into evidence

are incorporated herein by reference.      When the petition was

filed, petitioners resided in California.

     During 2005 petitioner Nicholas Damer (Mr. Damer) worked as

a licensed private investigator and as an attorney.      Petitioner

Margaret Flynn worked as an independent contractor performing

pediatric physical therapy.



     1
      The amounts of petitioners’ tuition and fees deduction,
itemized deductions, alternative minimum tax, self-employment
tax, and self-employment tax deduction are computational matters
to be resolved in the parties’ Rule 155 computations consistent
with the Court’s decision. See secs. 55-59, 164(f), 222, 1401,
1402.
                               - 3 -

     Sometime in 1986 petitioners constructed an office building,

Liberty Court, which houses Mr. Damer’s law practice and is also

held by petitioners as rental real estate.

     Over the years petitioners acquired several loans that were

used to construct or improve Liberty Court, to fund Mr. Damer’s

law practice, and to improve petitioners’ personal residence.

For example, in September 1998 petitioners acquired a $650,000

loan from First National Bank of Northern California (FNB) in

order to renew or modify an existing commercial real estate loan.

The FNB loan was secured by Liberty Court.   In December 2005 they

acquired a $540,508.05 loan from Bank of America (BOA).   The BOA

loan was used to pay off the FNB loan, and it too was secured by

Liberty Court.   In December 2002 they acquired a $644,000 loan

from HomeComings Financial (HCF) that was secured by a first

mortgage on their residence.   In January 2004 they acquired a

$100,000 line of credit from HCF that was secured by a second

mortgage on their residence.   In October 2005 they acquired a

$975,340.58 loan from HCF.   The 2005 HCF loan was used to pay off

the 2002 and 2004 HCF loans, and it also was secured by a first

mortgage on their residence.   In November 2005 petitioners

acquired a $195,000 loan from Greenpoint Mortgage Funding, Inc.

(GMF), which was secured by a second mortgage on their residence.
                               - 4 -

     With each loan, petitioners financed certain fees, charges,

or taxes, and in some instances they received cash or “Refunds”

from the loan proceeds.   They also claimed deductions for

mortgage interest, points, and fees, charges, or taxes on their

2005 Form 1040, U.S. Individual Income Tax Return.    On Schedule

C, Profit or Loss From Business, they claimed a deduction for

mortgage interest of $58,057 with respect to Mr. Damer’s law

practice.   On Schedule E, Supplemental Income and Loss, they

claimed deductions for mortgage interest of $31,868 and bank fees

of $33.   On Schedule A, Itemized Deductions, they claimed

deductions for mortgage interest of $16,936 and points of $4,875.

During the examination of their return, Mr. Damer told

respondent’s Appeals officer that their deductions for mortgage

interest included points, fees, charges, or taxes from previous

loans that were paid when those loans were refinanced in 2005.

     From third-party payor reports respondent determined that

petitioners paid mortgage interest of:    (1) $28,034 to HCF; (2)

$35,945 to FNB; (3) $10,018 to HCF; and (4) $672 to HCF.

Respondent disallowed a portion of petitioners’ deductions for

mortgage interest because the amounts they claimed were more than

the amounts their lenders reported.    Respondent then allocated

petitioners’ deductions for mortgage interest to Schedules C, E,

and A, respectively, because he could not match “specific
                                  - 5 -

mortgage interest to specific Forms or Schedules”.2        But

respondent made no adjustment to petitioners’ Schedule A

deduction for points of $4,875.

                                Discussion

I.    Burden of Proof

       The Commissioner’s determinations in a notice of deficiency

are presumed correct, and the taxpayer bears the burden to prove

that the determinations are in error.        Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).         But the burden of proof on

factual issues that affect the taxpayer’s tax liability may be

shifted to the Commissioner if the taxpayer introduces credible

evidence with respect to the issue.       Sec. 7491(a)(1).

Petitioners bear the burden of proof because they have neither

alleged that section 7491(a) applies nor proven that they have

complied with the substantiation and recordkeeping requirements

of section 7491(a)(2)(A) and (B).

II.    Deductions for Mortgage Interest

      A.   General Principles

       Taxpayers are generally allowed to deduct all interest paid

or accrued within the taxable year on indebtedness.        Sec. 163(a).

But in the case of a taxpayer other than a corporation, no

deduction is allowed for personal interest.        Sec. 163(h)(1).


       2
      It is unclear from the record the amounts of mortgage
interest from each loan that respondent allocated to each
schedule.
                               - 6 -

“Personal interest” includes any interest allowable as a

deduction other than:   (1) Interest paid or accrued on

indebtedness properly allocable to a trade or business (other

than the trade or business of performing services as an

employee); (2) any interest that is taken into account under

section 469 in computing income or loss from a passive activity

of the taxpayer; and (3) any qualified residence interest.    Sec.

163(h)(2)(A), (C), (D).   “[Q]ualified residence interest” means

any interest that is paid or accrued during the taxable year on

acquisition indebtedness3 or home equity indebtedness4 with

respect to any qualified residence of the taxpayer.   Sec.

163(h)(3)(A).   In addition, if a taxpayer prepays an interest



     3
      “[A]cquisition indebtedness” means any indebtedness that is
incurred in acquiring, constructing, or substantially improving
any qualified residence of the taxpayer and is secured by the
residence. Sec. 163(h)(3)(B)(i). Acquisition indebtedness also
includes any indebtedness secured by the residence resulting from
the refinancing of acquisition indebtedness but only to the
extent the amount of the indebtedness resulting from the
refinancing does not exceed the amount of the refinanced
indebtedness. Id. And the aggregate amount treated as
acquisition indebtedness for any period must not exceed $1
million ($500,000 if a married individual files a separate
return). Sec. 163(h)(3)(B)(ii).
     4
      “[H]ome equity indebtedness” means any indebtedness (other
than acquisition indebtedness) secured by a qualified residence
to the extent the aggregate amount of the indebtedness does not
exceed the fair market value of the qualified residence reduced
by the amount of acquisition indebtedness with respect to the
residence. Sec. 163(h)(3)(C)(i). And the aggregate amount
treated as home equity indebtedness for any period must not
exceed $100,000 ($50,000 if a married individual files a separate
return). Sec. 163(h)(3)(C)(ii).
                                - 7 -

obligation and computes his/her taxable income under the cash

method of accounting, then the prepayments of interest must be

spread over the term of the loan and deducted to the extent that

monthly payments on the loan include the ratable portions (except

certain “points” deductible pursuant to section 461(g)(2)).     Sec.

461(g)(1); Schubel v. Commissioner, 77 T.C. 701, 702-703 (1981);

Jackson v. Commissioner, T.C. Memo. 2005-159.

     For cash method taxpayers, like petitioners, a deduction

requires that mortgage interest be paid in cash or its

equivalent.   Don E. Williams Co. v. Commissioner, 429 U.S. 569,

578-579 (1977); Eckert v. Burnet, 283 U.S. 140, 141 (1931); Menz

v. Commissioner, 80 T.C. 1174, 1185 (1983).   A promissory note is

generally not considered the equivalent of cash but merely a

promise to pay.   Helvering v. Price, 309 U.S. 409, 413 (1940);

Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601, 624

(1964).   If the obligation to pay mortgage interest is satisfied

through the issuance of notes to the same lender to whom the

mortgage interest obligation is owed, there has been no payment

of mortgage interest; rather, payment has merely been postponed.

Davison v. Commissioner, 107 T.C. 35, 41 (1996), affd. 141 F.3d

403 (2d Cir. 1998); Stone v. Commissioner, T.C. Memo. 1996-507.

     As defined in caselaw “interest” means “compensation for the

use or forbearance of money.”    Deputy v. du Pont, 308 U.S. 488,

498 (1940).   Therefore, amounts characterized as mortgage
                               - 8 -

interest must be distinguished from fees, charges, or taxes,

which are computed without regard to the amount borrowed, the

duration of the loan, the degree of credit risk, or the condition

of the money market.   Id.; Pac. First Fed. Sav. & Loan

Association v. Commissioner, 79 T.C. 512 (1982).   To the extent

that the loan proceeds were used for business or investment

purposes, the fees or charges might be deductible over the life

of the loan under section 162(a) or 212.   Goodwin v.

Commissioner, 75 T.C. 424, 439-442 (1980), affd. 691 F.2d 490 (3d

Cir. 1982); Wilkerson v. Commissioner, 70 T.C. 240, 262-263

(1978), revd. on other grounds 655 F.2d 980 (9th Cir. 1981);

Lovejoy v. Commissioner, 18 B.T.A. 1179 (1930); Trivett v.

Commissioner, T.C. Memo. 1977-161, affd. 611 F.2d 655 (6th Cir.

1979).

     In addition, certain fees, charges, or taxes--such as

recording or transfer fees/taxes--are costs of acquiring the

property and must be capitalized and included in the property’s

basis pursuant to section 263(a)(1).   Thompson v. Commissioner, 9

B.T.A. 1342, 1345 (1928); Erfurth v. Commissioner, T.C. Memo.

1987-232; Gibbons v. Commissioner, T.C. Memo. 1976-125.

     If the loan proceeds were used for personal purposes, then

the fees, charges, or taxes cannot be deducted or capitalized

(except certain “points” deductible pursuant to section

461(g)(2)).   Sec. 262(a); Hendrick v. Commissioner, 35 T.C. 1223,
                               - 9 -

1235 (1961); Rev. Rul. 67-297, 1967-2 C.B. 87 (loan origination

fee (or points) paid in connection with the acquisition of a home

mortgage loan guaranteed by the Veterans’ Administration is a

charge for services and is neither deductible as interest nor

treated as an additional cost of the property); cf. Goodwin v.

Commissioner, supra at 439-442.

     With these principles in mind, the Court now turns to

petitioners’ deductions for mortgage interest and related fees,

charges, or taxes.

     B.   FNB Mortgage Interest and Related Fees, Charges, or
          Taxes

     Petitioners provided a BOA loan document that shows that

they used some of the BOA loan proceeds to pay mortgage interest

of $1,613.36 to FNB in December 2005.

     The Court finds that petitioners paid mortgage interest of

$1,613.36 to FNB in December 2005 from the BOA loan proceeds.

But because petitioners have not proven that the $1,613.36 was

not included in the $35,945 that respondent allowed as a

deduction for mortgage interest paid to FNB in 2005, they

nevertheless are not entitled to deduct the $1,613.36.   See

Davison v. Commissioner, supra at 41; Stone v. Commissioner,

supra.
                              - 10 -

     The FNB loan document shows that petitioners also financed:

                    Description                        Amount

     “Modification Endorsement 110.5 Fee”               $850
     Recording                                            50
     Tax lien service fee                                 55
     Document preparation fee                            250
     Flood certificate fee                                40
     Loan fees                                         6,500

     Pursuant to Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d

Cir. 1930), the Court finds that petitioners are entitled under

sections 162(a) and/or 2125 to deductions of $2,821.72 for the

fees or charges that were paid or incurred in 2005.6   See Crown

v. Commissioner, 77 T.C. 582, 593-595 (1981); Wilkerson v.

Commissioner, supra at 262-263; McAdams v. Commissioner, 15 T.C.

231, 234-235 (1950), affd. 198 F.2d 54 (5th Cir. 1952).   In

addition, consistent with petitioners’ previous Federal income

tax returns, they should allocate the deductible amounts equally

to Schedules C and E.   See Estate of Ashman v. Commissioner, 231

F.3d 541, 543 (9th Cir. 2000), affg. T.C. Memo. 1998-145.    But

petitioners are not entitled to deduct the recording fee.    See


     5
      An individual’s rental real estate activity can constitute
a trade or business for purposes of sec. 162(a). See, e.g.,
Hazard v. Commissioner, 7 T.C. 372 (1946). But see, e.g.,
Balsamo v. Commissioner, T.C. Memo. 1987-477 (rental real estate
activity did not constitute a trade or business; rather, the
property was held for the production of income within the meaning
of sec. 212(1)).
     6
      $7,695 (total allowable FNB loan fees or charges) ÷ 10
years (amortization period) = $769.50 per year ÷ 12 months (per
year) = $64.13 per month x 44 months (remaining amortization
period of the FNB loan as of Jan. 1, 2005) = $2,821.72.
                              - 11 -

Thompson v. Commissioner, supra at 1345; Erfurth v. Commissioner,

supra; Gibbons v. Commissioner, supra.

     C.   BOA Mortgage Interest and Related Fees, Charges, or
          Taxes

     Petitioners have not shown that they paid mortgage interest

to BOA in 2005; therefore, they are not entitled to a mortgage

interest deduction for that loan.    See secs. 163(a), 6001.

     The BOA loan documents show that petitioners also financed:

                     Description                        Amount

     Flood fee                                            $30
     Reconveyance fee                                      15
     Documentation fee                                     30
     “ALTA” loan policy premium (title insurance)       1,146
     Endorsements (title insurance)                       100
     Escrow fee                                           850
     Recording fee                                         20
     Recording fee for reconveyance to come                20
     Notary fees                                           20
     “Overnight/Courier/Misc.” fees                        60

     Pursuant to Cohan v. Commissioner, supra at 543-544, the

Court finds that petitioners are entitled to deduct under

sections 162(a) and/or 212 the 2005 amortizable amounts of the

fees or charges (i.e., $18.637).    See Crown v. Commissioner,

supra at 593-595; Wilkerson v. Commissioner, supra at 262-263;

McAdams v. Commissioner, supra at 234-235.    Again, petitioners


     7
      Petitioners failed to establish the amortization period of
the BOA loan. The Court assumes that the BOA loan was
amortizable over 10 years. See Cohan v. Commissioner, 39 F.2d
540, 543-544 (2d Cir. 1930). Thus, $2,236 (total allowable BOA
loan fees or charges) ÷ 10 years (amortization period) = $223.60
per year ÷ 12 months (per year) = $18.63 per month x 1 month
(Dec. 2, 2005)= $18.63.
                               - 12 -

should allocate the deductible amounts equally to Schedules C and

E.   See Estate of Ashman v. Commissioner, supra at 543.    But

petitioners are not entitled to deduct the reconveyance fee,

recording fee, or recording fee for reconveyance to come.     See

Thompson v. Commissioner, 9 B.T.A. at 1345; Erfurth v.

Commissioner, T.C. Memo. 1987-232; Gibbons v. Commissioner, T.C.

Memo. 1976-125.

     D.   HCF and GMF Mortgage Interest and Related Fees, Charges,
          or Taxes

           1.   Mortgage Interest

     Respondent contends that because petitioners obtained the

proceeds to pay off the 2002 and 2004 HCF loans from the same

lender and never had unfettered access to the funds used to pay

off those loans, they are not entitled to deduct the outstanding

interest obligations (i.e., $3,811.958) that were paid when they

refinanced the 2002 and 2004 HCF loans with the 2005 HCF loan.

     Petitioners, on the other hand, contend that the HCF and GMF

loans “in part, refinanced debt going back to the 1970’s and

related to [p]etitioner Damer’s law practice.”   Therefore,

according to petitioners, they are entitled to deduct any

mortgage interest paid in 2005 and to deduct any fees, charges,




     8
      The $3,811.95 is based on mortgage interest of $340.58 +
$1,872.36 + $1,515.72 + $45.04 + $38.25 from Sept. 9 to Oct. 8,
2005.
                              - 13 -

or taxes to the extent that they were paid or incurred to finance

Mr. Damer’s law practice.

     The Court finds that petitioners are not entitled to deduct

the outstanding interest obligations of the 2002 and 2004 HCF

loans that were “paid” with the 2005 HCF loan because the

interest was not paid within the meaning of section 163(a).    See

Davison v. Commissioner, 107 T.C. at 41.   The Court therefore

finds that petitioners’ HCF mortgage interest deductions are

limited to the amounts respondent determined; i.e., $28,034,

$10,018, and $672.   In addition, the amounts should be allocated

to Schedules A and C according to the percentages of each loan

that the Court has determined were used to finance Mr. Damer’s

law practice, see infra pp. 16-18; i.e.:   (1) 85.2 percent to

Schedule A and 14.8 percent to Schedule C for the 2002 HCF loan;

(2) 85.8 percent to Schedule A and 14.2 percent to Schedule C for

the 2004 HCF loan; and (3) 60.4 percent to Schedule A and 39.6

percent to Schedule C for the 2005 HCF loan.9

     Petitioners have not shown that they paid mortgage interest

to GMF in 2005; therefore, they are not entitled to a mortgage

interest deduction for that loan.   See secs. 163(a), 6001.




     9
      It is unclear from the notice of deficiency (and the
record) which HCF loan is attributable to the amounts respondent
allowed for mortgage interest deductions. The Court leaves this
to the parties to sort out in their Rule 155 computations.
                                 - 14 -

     2.   HCF- and GMF-Related Fees, Charges, or Taxes

     The 2002 HCF loan document shows that petitioners financed:

           Description                                  Amount

     Loan origination fee                             $3,220.00
     Appraisal fee                                       500.00
     Credit report                                        20.00
     Tax service                                          98.00
     Document fee                                        161.00
     Closing fee                                         100.00
     Underwriting fee                                    350.00
     Flood certificate fee                                10.50
     Wire fee                                              5.00
     Demand/statement fee                                 50.00
     ALTA loan policy fee                              1,315.55
     Recording trust deed                                 59.00
     Escrow fee                                          350.00
     Notary fee                                           40.00
     Courier/overnight fee                                30.00

     The 2002 HCF loan document does not show the amortization

period of that loan.      But it shows that petitioners received a

refund of $95,376.66 from the loan proceeds.

     The 2004 HCF loan document shows that petitioners financed:

           Description1                                  Amount

     Loan origination fee                              $1,000.00
     Credit report                                         20.00
     Funding review fee                                    95.00
     Processing fee                                       395.00
     Additional items                                     195.50
     Title insurance                                      110.00
     Recording trust deed                                  25.00
     Escrow fee                                           250.00
     Notary fee                                            60.00
     Courier/overnight fee                                 30.00
     1
      Petitioners were also required to pay in advance hazard
insurance of $3,663 and “Banana Republic misc. acct” of $24.
Petitioners, however, have not shown that the amount of the
hazard insurance attributable to Mr. Damer’s law practice was not
deductible in 2004. See sec. 1.263(a)-4(f)(1), (8), Income Tax
                              - 15 -

Regs. Thus, petitioners cannot deduct any portion of the hazard
insurance in 2005. In addition, the Court surmises, and
petitioners have not proven otherwise, that the $24 for Banana
Republic misc. acct was a personal expenditure. Consequently,
petitioners are not entitled to deduct any portion of that amount
in 2005. See sec. 262(a).

     The 2004 HCF loan document does not show the amortization

period of that loan.   But it shows that petitioners received cash

of $14,162.50 from the loan proceeds.

     The 2005 HCF loan document shows that petitioners financed:

     Description1                                     Amount

     Appraisal fee                                      $150
     Credit report                                        35
     Tax service                                         128
     Funding review fee                                  266
     Processing fee                                      395
     Underwriting fee                                    450
     Flood certificate fee                                 6
     Wire fee                                              5
     Demand/statement fee                                 44
     ALTA loan policy fee                              1,785
     1st lender endorsement
       (title insurance)                                  50
     Recording trust deed                                 75
     Escrow fee                                          500
     Notary fee                                           40
     Courier/overnight fee                                45
     1
      Petitioners also financed a loan origination fee of $4,875
that they deducted on Schedule A as points, and respondent made
no adjustment to it. See supra pp. 4-5.

     The 2005 HCF loan document shows that petitioners financed

the principal and related fees, charges, or taxes for a 30-year

amortization period.   It also shows that petitioners received a

refund of $386,041.93 from the loan proceeds.
                               - 16 -

     The GMF loan document shows that petitioners financed:

          Description                               Amount

       Document fee                                  $295
       Processing fee                                 395
       “CB Tahoe for misc. collection”                133
       Notary fee                                      60
       ALTA loan policy fee                           617
       Recording trust deed                            65
       Escrow fee                                     250
       Courier/overnight fee                           30
       “Edocs” processing fee                          50

     The GMF loan document does not show the amortization period

of that loan.   In addition, it shows that petitioners did not

receive cash or a refund from the loan proceeds.

     To the extent that the fees or charges were incurred in

connection with the acquisition, construction, or improvement of

petitioners’ residence, the fees or charges are nondeductible

personal expenses (except the deduction for points of $4,875 that

respondent allowed).    See sec. 262(a); Goodwin v. Commissioner,

75 T.C. at 439-442; Hendrick v. Commissioner, 35 T.C. at 1235.

To the extent that the fees or charges were incurred in

connection with Mr. Damer’s law practice, petitioners are

entitled to deduct those amounts under section 162(a) as

determined infra.   See Goodwin v. Commissioner, supra at 439-442;

Wilkerson v. Commissioner, 70 T.C. at 262-263.     But in no case

are petitioners entitled to deduct the recording fees.       See

Thompson v. Commissioner, 9 B.T.A. at 1345; Erfurth v.
                                 - 17 -

Commissioner, T.C. Memo. 1987-232; Gibbons v. Commissioner, T.C.

Memo. 1976-125.

     Petitioners failed to establish the amount of the proceeds

of each loan that was used to finance Mr. Damer’s law practice.

Pursuant to Cohan v. Commissioner, 39 F.2d at 543-544, the Court

finds that only 14.810 percent of the 2002 HCF loan was used to

finance Mr. Damer’s law practice.     The Court also finds that the

2002 HCF loan was amortizable over 30 years.     See id.     Therefore,

petitioners are entitled to a deduction of $829.8811 under

section 162(a) for the outstanding amortizable fees or charges of

the 2002 HCF loan that were paid or incurred in 2005.       See id.

     The Court finds that only 14.212 percent of the 2004 HCF

loan was used to finance Mr. Damer’s law practice.        See id.   The

Court also finds that the 2004 HCF loan was amortizable over 30

years.     See id.   Therefore, petitioners are entitled to a

deduction of $299.2613 under section 162(a) for the outstanding



     10
          $95,376.66 (refund) ÷ $644,000 (2002 HCF loan).
     11
      $6,250.05 (total allowable 2002 HCF loan fees or charges)
÷ 30 years (amortization period) = $208.34 (amortizable per year)
÷ 12 months (per year) = $17.36 per month x 323 months (remaining
amortization period/months as of Jan. 1, 2005) x 14.8% (loan
proceeds attributed to law practice) = $829.88.
     12
          $14,162.50 (cash) ÷ $100,000 (2004 HCF loan).
     13
      $2,180 (total allowable 2004 HCF loan fees or charges) ÷
30 years (amortization period) = $72.67 (amortizable per year) x
29 years (remaining amortization period as of Jan. 1, 2005) x
14.2% (loan proceeds attributed to law practice) = $299.26.
                                  - 18 -

fees or charges of the 2004 HCF loan that were paid or incurred

in 2005.     See id.

     The Court finds that only 39.614 percent of the 2005 HCF

loan was used to finance Mr. Damer’s law practice.       See Cohan v.

Commissioner, supra at 543-544.       Therefore, petitioners are

entitled to a deduction of $12.8715 under section 162(a) for the

fees or charges that were paid or incurred with respect to the

2005 HCF loan.     See id.

     The Court finds, however, that no portion of the 2005 GMF

loan was used to finance Mr. Damer’s law practice; petitioners

have not proven otherwise.       See id.   Consequently, petitioners

are not entitled to deduct any fees or charges with respect to

the 2005 GMF loan.     See id.

     E.     2002 Mortgage Interest Carried Over to 2005

     Mr. Damer testified that when their 2002 Federal income tax

return was audited in 2005, respondent disallowed Schedule E

deductions of $27,900 because the amount exceeded the passive

activity loss limitations of section 469.       Petitioners contend

that they are entitled to carry over the 2002 passive activity

loss to 2005.     They assert that 51.54 percent of that amount



     14
          $386,041.93 (refund) ÷ $975,340.58 (2005 HCF loan).
     15
      $3,899 (total allowable 2005 HCF loan fees or charges) ÷
30 years (amortization period) = $129.97 (amortizable per year) ÷
12 months (per year)= $10.83 x 3 months (Oct. 4 to Dec. 31, 2005)
x 39.6% (loan proceeds attributed to law practice) = $12.87.
                                - 19 -

(i.e., $14,380) was interest and that the amount can be added to

the mortgage interest deductions claimed on their 2005 Schedules

C and E.

     Section 469(b), however, provides that if any loss or credit

from an activity is disallowed under section 469(a), then the

loss or credit is treated as a deduction or credit allocable to

the activity in the next taxable year.     See also sec. 1.469-

1(f)(4), Income Tax Regs. (any disallowed deductions or credits

are allocated among the taxpayer’s activities for the succeeding

taxable year).     Consequently, petitioners’ $27,900 passive

activity loss from 2002 was to be carried over to 2003, not to

2005.     Petitioners also failed to establish that any of the 2002

passive activity loss remains to be deducted in 2005 after being

carried over to 2003 and then to 2004.16    See Wilkinson v.

Commissioner, 71 T.C. 633, 639 (1979); Halle v. Commissioner, 7

T.C. 245, 247-250 (1946), affd. 175 F.2d 500 (2d Cir. 1949);

Baker v. Commissioner, T.C. Memo. 2008-247 (statements in tax

returns are only claims of the taxpayer, not proof of his/her

deductions or losses).




     16
      On Form 8582, Passive Activity Loss Limitations,
petitioners reported a prior year’s unallowed loss of $39,087.
                               - 20 -

III.    Passive Activity Loss Limitations

       On petitioners’ 2005 Schedule E and Form 8582, they reported

passive activity losses of $68,660,17 of which they reported zero

as their “Deductible rental real estate loss”.     They claimed that

amount (i.e., zero) on line 17 of their Form 1040.

       Petitioners contend that they are not subject to the passive

activity loss limitations of section 469 and that they are

entitled to deduct their Schedule E losses without limit because

they meet the test for material participation.

       Section 469(a) generally disallows any passive activity

loss18 or passive activity credit.19    The term “passive activity”

includes any trade or business in which the taxpayer does not

materially participate, any activity engaged in for the

production of income, and any rental activity regardless of

whether the taxpayer materially participates.20    Sec. 469(c)(1),


       17
      Based on 2005 losses of $19,030 (property A) + $5,327
(property B) + $5,216 (property C) + $39,087 (prior years’
unallowed losses).
       18
      “Passive activity loss” means the excess of the aggregate
losses over the aggregate income from all passive activities.
Sec. 469(d)(1).
       19
      “Passive activity credit” means the amount, if any, by
which the sum of the credits from all passive activities
allowable for the taxable year under subpt. D of pt. IV of subch.
A or subpt. B (other than sec. 27(a)) exceeds the regular tax
liability of the taxpayer for the taxable year allocable to all
passive activities. Sec. 469(d)(2).
       20
      Material participation means that the taxpayer is involved
in the activity’s operations on a regular, continuous, and
                                                   (continued...)
                                - 21 -

(2), (4), (6).     But under section 469(c)(7) rental activities of

a qualifying taxpayer in a real property trade or business are

not a per se passive activity under section 469(c)(2).      Kosonen

v. Commissioner, T.C. Memo. 2000-107.      Rather, the qualifying

taxpayer’s rental activities are treated as a trade or business--

subject to the material participation requirements of section

469(c)(1).     Fowler v. Commissioner, T.C. Memo. 2002-223; sec.

1.469-9(e)(1), Income Tax Regs.

     A taxpayer may qualify for the real property trade or

business exception if:    (1) 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

(2) the taxpayer performs more than 750 hours of services during

the taxable year in real property trades or businesses in which

the taxpayer materially participates.      Sec. 469(c)(7)(B)(i) and

(ii).     In the case of a joint return, either spouse must satisfy

both requirements.    Sec. 469(c)(7)(B).

     Each petitioner failed to establish that more than one-half

of the personal services he/she performed in trades or businesses

were performed in real property trades or businesses during 2005



     20
      (...continued)
substantial basis. Sec. 469(h); see also sec. 1.469-5T(a),
Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988) (an
individual is treated as materially participating if the
individual satisfies any one of the seven enumerated tests).
                                  - 22 -

and that he/she performed more than 750 hours of services during

2005 in real property trades or businesses.     Thus, the Court need

not decide whether they materially participated.     Consequently,

petitioners’ passive activity losses or credits for 2005 are

limited by section 469.

IV.    Accuracy-Related Penalty

       Respondent determined a section 6662(a) accuracy-related

penalty based on petitioners’ substantial understatement of their

2005 Federal income tax.21

       In pertinent part, section 6662(a) and (b)(2) imposes an

accuracy-related penalty equal to 20 percent of the underpayment

that is attributable to a substantial understatement of income

tax.    A substantial understatement of income tax exists if the

amount of the understatement for the taxable year exceeds the

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

return for the taxable year or $5,000.     Sec. 6662(d)(1)(A).   The

term “understatement” means the excess of the amount of the tax

required to be shown on the return for the taxable year over the

amount of the tax imposed that is shown on the return less any

rebate as defined by section 6211(b)(2).     Sec. 6662(d)(2)(A).

The amount of the understatement is reduced by the portion of the

understatement that is attributable to:     (1) The taxpayer’s tax



       21
      The Court therefore need not discuss whether petitioners
were negligent or disregarded rules or regulations. See sec.
6662(b); Fields v. Commissioner, T.C. Memo. 2008-207.
                               - 23 -

treatment of the item if there is or was substantial authority

for the treatment; or (2) any item if the relevant facts

affecting the item’s tax treatment are adequately disclosed in

the return or in a statement attached to the return and there is

a reasonable basis for the taxpayer’s tax treatment of the item.

Sec. 6662(d)(2)(B).22

     Initially, the Commissioner has the burden of production

with respect to any penalty, addition to tax, or additional

amount.   Sec. 7491(c).   The Commissioner satisfies this burden of

production by coming forward with sufficient evidence that

indicates that it is appropriate to impose the penalty.    See

Higbee v. Commissioner, 116 T.C. 438, 446 (2001).    Once the

Commissioner satisfies this burden of production, the taxpayer

must persuade the Court that the Commissioner’s determination is

in error by supplying sufficient evidence of an applicable

exception.   Id.

     In view of the computational adjustments, see supra note 1,

and the Court’s holdings herein, it is unclear whether there is a

substantial understatement of income tax for 2005.   The Court

leaves for the parties to determine as part of the Rule 155

computations whether there is a substantial understatement.      If a

substantial understatement exists, petitioners are liable for the



     22
      Petitioners have not proven that they satisfy the adequate
disclosure and substantial authority provisions. See sec.
6662(d)(2)(B).
                              - 24 -

accuracy-related penalty because respondent will have met his

burden of production and petitioners have not established a

reasonable cause or good faith defense.

V.   Conclusion

      In sum, respondent’s determinations are sustained except as

otherwise stated; and to the extent that a substantial

understatement of income tax exists, petitioners are liable for a

section 6662(a) accuracy-related penalty.

      To reflect the foregoing,


                                          Decision will be entered

                                    under Rule 155.
