                               T.C. Memo. 2017-65



                        UNITED STATES TAX COURT



         ZANE W. PENLEY AND MONIKA J. PENLEY, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 13243-15.                         Filed April 17, 2017.



      Zane W. Penley and Monika J. Penley, pro se.

      Philip E. Blondin, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      WHERRY, Judge: Respondent determined deficiencies in petitioners’

income tax for the taxable years 2010 through 2012. Petitioners assert that

respondent erred for the taxable year 2012 in disallowing deductions for their
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[*2] losses from their real estate activities under the section 4691 passive activity

loss rules because petitioner-husband (Mr. Penley) qualified as a real estate

professional under section 469(c)(7) for that year.

      After concessions by respondent,2 the principal issue for decision is whether

Mr. Penley qualified as a real estate professional for 2012. We find that he did

not. We also determine that petitioners are not entitled to additional deductions

for mortgage insurance premiums for 2011 and 2012 and that they are liable for an

accuracy-related penalty under section 6662(a) for 2012.

                               FINDINGS OF FACT

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

in the stipulations of the parties with accompanying exhibits are incorporated




      1
      All section references are to the Internal Revenue Code of 1986, as
amended and in effect during the years at issue. All Rule references are to the Tax
Court Rules of Practice and Procedure, unless otherwise indicated. All monetary
amounts are rounded to the nearest dollar.
      2
       Respondent conceded the other income adjustments of $43,500 and
$157,557 for the 2011 and 2012 taxable years, respectively. Respondent also
concedes that petitioners are entitled to vehicle depreciation expenses of $11,060
and $8,990 for the 2010 and 2011 taxable years, respectively. (We note that
$8,990 is in excess of the amount claimed on petitioners’ return for 2011.)
Finally, respondent concedes that petitioners are entitled to deduct a capital loss of
$3,000 for the 2012 taxable year.
                                         -3-

[*3] herein by reference. At the time the petition was filed, petitioners resided in

Colorado.

      During 2012 Mr. Penley was a full-time employee of HSS, Inc. (HSS).

From January through September 2012 Mr. Penley worked as an entry-level field

sterilization technician, and from October through December 2012 he worked as a

sales account representative. Although Mr. Penley performed many of his duties

from petitioners’ home, he would travel to client sites as needed. These trips

could take under half an hour in the case of a local client, or they could on

occasion require him to travel several hours throughout Colorado. In all, Mr.

Penley spent at least 2,194 hours, including occasional overtime, during 2012

performing his duties for HSS.

      During 2012, Mr. Penley was also actively engaged as a Colorado licensed

real estate broker, and he had an active business marketing commercial and

residential properties for several clients. Petitioners also conducted a rental real

estate activity through a subchapter S corporation named Harvey Herbert, Inc.

(HHI). Petitioners each owned 50% of HHI. During the taxable years 2010-12

HHI owned two single-family residential properties in Littleton, Colorado.

Petitioners also held a warehouse in Sedalia, Colorado, in a self-directed

individual retirement account through a limited liability company, Flying Bee
                                         -4-

[*4] Ranch, LLC. Petitioners spent time performing various tasks in the course of

managing HHI’s affairs such as finding tenants, managing the Corporation’s

finances, and making repairs to the properties.

The Sterne Property

      Petitioners were introduced to Ms. Betty Lou St. Clair (Ms. St. Clair)

through a mutual acquaintance, and they thereafter served as her real estate

advisers. On August 19, 2011, acting on petitioners’ advice, Ms. St. Clair

purchased a property on South Sterne Circle in Littleton, Colorado (Sterne

property). Ms. St. Clair made a downpayment of $4,212 on the Sterne property

and executed a mortgage in her name for $161,888, the remaining balance of the

purchase price.

      The Sterne property is a duplex, with a front unit facing the street and a rear

unit at the back of the lot. Ms. St. Clair planned to live in the rear unit while

renting out the front unit to supplement her income. Because the rear unit was

occupied by unauthorized tenants, neither Ms. St. Clair nor petitioners were able

to inspect the rear unit throughly until shortly before closing.

      When petitioners and Ms. St. Clair were finally able to inspect the rear unit

of the property, it became apparent that it would not be a suitable residence for

her. The prior occupants left the property in a generally filthy condition, which
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[*5] included damaged, buckled flooring, bare electrical wiring, and plumbing

leaks. Ms. St. Clair never moved into either unit of the Sterne property and

apparently found different living accommodations.

      Petitioners may have had some legal obligation to Ms. St. Clair in

connection with their role advising her with respect to the Sterne property.3

However, even without a legal obligation, petitioners felt the need to protect their

reputation as real estate brokers and advisers by making Ms. St. Clair whole on the

transaction. And while the Sterne property was in poor condition, petitioners felt

that the rear unit was structurally sound and could be rehabilitated.

      On August 15, 2011, Ms. St. Clair as grantor executed a document entitled

“Certification of The ‘St. Clair Trust’ Agreement” (certification document).

Petitioners executed the certification document as trustees. The certification

document recites that “[t]he ‘St. Clair Trust’ is a ‘Grantor Trust’ within the

meaning of such term as used in the Internal Revenue Code, and all items of

income and loss will be reported for tax purposes under the personal social

security number of the Grantor, Betty Lou St. Clair.” On August 19, 2011, Ms. St.


      3
        Under Colorado law real estate brokers or transaction brokers do not have
an affirmative duty to inspect property on behalf of their clients; however, they
must discharge their responsibilities with a reasonable level of care. See Colo.
Rev. Stat. Ann. secs. 12-61-805, 12-61-807 (West 2016).
                                        -6-

[*6] Clair executed a quitclaim deed transferring the Sterne property to the “St.

Clair Trust”. The Sterne property has been titled in the name of the St. Clair Trust

since that time.

      On August 15, 2011, petitioners also executed a second document entitled

“The ‘St. Clair’ A Revocable Trust Agreement” (trust document). The trust

document generally purports to create a trust which includes the Sterne property as

part of the trust estate. The trust document lists petitioners as trustees and makes

no mention of Ms. St. Clair. Ms. St. Clair may never have actually seen this trust

document, and she did not execute it herself. Petitioners prepared the certification

document and the trust document themselves using forms they received from an

“asset protection” attorney based in Utah and Florida.

      On August 15, 2012, petitioners acting through HHI leased the front unit of

the Sterne property to a tenant. During 2012 petitioners also spent significant time

and effort repairing the damage to the rear unit of the Sterne property. Petitioners

have performed substantially all of the work on the Sterne property themselves,

including installing new flooring, wiring, and plumbing. However, even as late as

2015 work on the rear unit was still incomplete, and it has never been occupied or

offered for rent since petitioners purchased the Sterne property.
                                        -7-

[*7] Petitioners, through HHI, have made all of the mortgage and insurance

payments and have paid all of the property taxes on the Sterne property. Ms. St.

Clair has not received any rent from the front unit and has not paid for any of the

expenses associated with renovating the rear unit of the Sterne property.

However, Ms. St. Clair remains liable for the mortgage she signed to purchase the

Sterne property. Petitioners have not assumed the mortgage, and they do not

currently have a plan or a fixed time to refinance the Sterne property in their own

names.

Evergreen Park

      During April 2012, petitioners were contacted about the possibility of

purchasing a property called Evergreen Park in Colorado Springs, Colorado.

Evergreen Park is a mobile home facility about an hour’s drive from petitioners’

home in Littleton, Colorado. From April through August 2012, petitioners spent

time performing various regulatory and due diligence activities with respect to

Evergreen Park such as negotiating the purchase terms and securing financing.

Petitioners acquired Evergreen Park on August 15, 2012, and thereafter they made

frequent trips to make improvements to the property.
                                         -8-

[*8] Returns and Audit

        Petitioners and HHI paid to have their Federal income tax returns for the

taxable years 2010-12 prepared using information that petitioners provided. HHI

filed a 2012 Form 1120S, U.S. Income Tax Return for an S Corporation, on which

it reported a nonpassive ordinary business loss of $96,354. HHI’s return did not

report any passive loss from real estate activities. HHI reported this loss to

petitioners on Schedules K-1, Shareholder’s Share of Income, Deductions, Credits

etc.

        Petitioners filed a joint income tax return for 2012 on Form 1040, U.S.

Individual Income Tax Return, on which they reported total income of $24,092

and taxable income of zero. Petitioners’ individual return included a Schedule E,

Supplemental Income and Loss, which reflected the $96,354 passthrough loss

from HHI in two equal parts of $48,177, one for each petitioner, as a nonpassive

loss.

        Respondent examined petitioners’ and HHI’s returns for taxable years 2010

through 2012. Respondent determined that $56,863 of HHI’s reported loss for

2012 was a passive loss from real estate activities and that Mr. Penley did not

qualify as a real estate professional under section 469(c)(7). After making

additional adjustments, respondent determined that petitioners’ income for the
                                         -9-

[*9] taxable year 2012 exceeded the phaseout threshold of section 469(i) and

disallowed petitioner’s deduction for the passive real estate loss in full.

Respondent also determined that petitioners were liable for an accuracy-related

penalty under section 6662(a) for 2012.

      In response to the notice of deficiency petitioners timely filed a petition

challenging respondent’s determination (inter alia) that Mr. Penley was not a real

estate professional for the 2012 taxable year.

                                      OPINION

      As a general rule, the Commissioner’s determination in the notice of

deficiency is presumed correct, and the taxpayer bears the burden of proving by a

preponderance of the evidence that the determination is improper. See Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Although section 7491(a)

may shift the burden of proof to the Commissioner in specified circumstances,

petitioners have not established that they meet the requirements under section

7491(a)(1) and (2) for such a shift. Consequently, the burden of proof remains on

petitioners.

      Deductions are a matter of legislative grace, and taxpayers bear the burden

of proving that they are entitled to any claimed deductions. Rule 142(a); see

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Taxpayers are required
                                        - 10 -

[*10] to identify each deduction, maintain adequate records, substantiate each

deduction, and show that they have met all requirements. Sec. 6001; Roberts v.

Commissioner, 62 T.C. 834, 836-837 (1974); sec. 1.6001-1(a), Income Tax Regs.

I. Real Estate Activity

      Taxpayers are generally allowed to deduct business and investment

expenses under sections 162 and 212, but section 469 puts strict limits on current

deductibility if a taxpayer incurs those expenses in a “passive activity”. Sec.

469(a). A passive activity is any trade or business in which the taxpayer does not

materially participate. Sec. 469(c)(1). A passive activity loss is the excess of the

aggregate losses from all passive activities for the year over the aggregate income

from all passive activities for that year. Sec. 469(d)(1). A rental activity is

generally treated as a per se passive activity regardless of whether the taxpayer

materially participates. Sec. 469(c)(2). There are special rules under section

469(c)(7) that allow a taxpayer in the real property business (real estate

professional) to deduct rental losses against other income provided that the

taxpayer materially participates in the rental activity. See also sec. 1.469-9(e)(1),

Income Tax Regs.

      Petitioners challenge respondent’s determination that a portion of the loss

reported by HHI for 2012 was a passive loss. They contend that Mr. Penley
                                          - 11 -

[*11] qualified as a real estate professional under section 469(c)(7) and that he

materially participated in his real estate activities. Petitioners do not contend that

Mrs. Penley qualified as a real estate professional.

      Under section 469(c)(7)(B), a taxpayer qualifies as a real estate professional

and a real estate activity of the taxpayer is not a per se passive activity under

section 469(c)(2) 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.

In the case of a joint return, the above requirements are satisfied if either spouse

separately satisfied these requirements. Sec. 469(c)(7)(B). Thus, if either spouse

qualifies as a real estate professional, the rental activities of the real estate

professional are exempt from being a per se passive activity under section

469(c)(2). Instead, the real estate professional’s rental activities would be subject

to the material participation requirements of section 469(c)(1). Sec. 1.469-9(e)(1),

Income Tax Regs.
                                        - 12 -

[*12] Petitioners claim that Mr. Penley spent approximately 2,520 hours on his

real estate activities during the taxable year 2012. Approximately 1,000 of the

claimed hours relate to the rehabilitation of the rear unit of the Sterne property.4

II. Substantiation of Hours Worked

      We turn to the question of whether petitioners have substantiated their claim

that Mr. Penley worked more hours in his real estate activities than he did in his

employment with HSS. While we acknowledge that Mr. Penley expended

significant efforts on his real estate activities during 2012, we are unable to credit

his testimony concerning the number of hours he spent on those activities.

      A taxpayer can use “any reasonable means” to prove the extent of his or her

participation in the real estate activities. Sec. 1.469-5T(f)(4), Temporary Income

Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). Reasonable means may include


      4
        Respondent argues that petitioners may not count toward Mr. Penley’s real
estate professional status for 2012 the time spent to rehabilitate the rear unit of the
Sterne property because petitioners did not have an ownership interest in the
Sterne property sufficient to allow them to have materially participated in the
activities of this unit. See sec. 1.469-5(f)(1), Income Tax Regs. We note that even
though petitioners did not own the Sterne property, Mr. Penley’s rehabilitation
efforts had a strong nexus to his real estate brokerage trade or business, in which
he participated. See 469(c)(7)(C); sec. 1.469-5(f)(1), Income Tax Regs. We need
not decide whether petitioners are entitled to count the time spent rehabilitating
the Sterne property towards real estate professional status because we find that
petitioners have not adequately substantiated the total time Mr. Penley spent on his
real estate activities.
                                        - 13 -

[*13] identifying of services performed over a period of time and the approximate

number of hours spent performing such services by using appointment books,

calendars, or other narrative summaries. Id. Although contemporaneous records

are not required, the use of a “postevent ‘ballpark guesstimate’” is not sufficient to

prove participation in a real estate activity. Fowler v. Commissioner, T.C. Memo.

2002-223, 84 T.C.M. (CCH) 281, 286 (2002); see also Mowafi v. Commissioner,

T.C. Memo. 2001-111, 81 T.C.M. (CCH) 1605, 1606 (2001); Rapp v.

Commissioner, T.C. Memo. 1999-249, 78 T.C.M. (CCH) 175, 177-178 (1999)

(holding that noncontemporaneous documents coupled with testimony are

insufficient methods of proof).

      Petitioners’ primary substantiation at trial for the hours Mr. Penley worked

during 2012 was a monthly calendar. The calendar indicates the property where

Mr. Penley worked on a particular day and contains a brief description of the work

performed, an estimate of the number of hours worked, and the number of miles

driven to and from the property.

      We find that this calendar greatly exaggerates the time Mr. Penley spent on

his real estate activities. Generally Mr. Penley claims, for 2012, to have worked

on his real estate activities 10-14 hours on each Saturday and Sunday during 2012

and an additional 4-6 hours most weekdays, in addition to another full-time job.
                                        - 14 -

[*14] Petitioners claim Mr. Penley worked 2,520 hours on his real estate activities.

To do so he would have had to work a total 4,714 hours (i.e., 2,194 for HHS %

2,520 on his real estate activities) in 2012. That means if he worked every day, he

would need to have averaged 12.88 total hours per day (i.e., 4,712 ÷ 366 ' 12.88).

We conclude the calendar is untrustworthy, and we will not naively accept it to

reach the result petitioners seek.

      Virtually all of the entries are rounded to the nearest hour or half-hour, do

not specify a start or end time for the work, include the time spent driving to and

from the property, and do not separate out any time for meals or other breaks. See

Merino v. Commissioner, T.C. Memo. 2013-167, at *8-*12; Rapp v.

Commissioner, 78 T.C.M. (CCH) at 177-178 (discounting testimony that lacked

specifics about time work was performed); Pohoski v. Commissioner, T.C. Memo.

1998-17, 75 T.C.M. (CCH) 1574, 1579 (1998) (noting that the large number of

hours claimed seemed implausible, especially given that the calendar did not

contain breaks for meals or leisure time with family).

      Corroborating evidence, such as credit card statements, phone bills, and

emails relating to the purchase of Evergreen Park, demonstrates meaningful real

estate activity by petitioners during 2012. However, petitioners have not provided

the Court with a sufficient explanation to reconcile this documentary evidence of
                                        - 15 -

[*15] their activities such as a brief email, a phone call, or a hardware store

purchase with the large blocks of time (often 4 hours to 14 hours) shown on the

calendar. See Hill v. Commissioner, T.C. Memo. 2010-200, 100 T.C.M. (CCH)

220, 223 (2010) (finding that the excessive hours claimed by the taxpayer, relative

to the tasks performed, diminished the credibility of the taxpayer’s estimates),

aff’d, 436 F. App’x 410 (5th Cir. 2011). We find that petitioners’ calendar does

not fall within the regulation’s “any reasonable means”. See sec. 1.469-5T(f)(4),

Temporary Income Tax Regs., supra.

      On the record before us we conclude that petitioners have not sufficiently

substantiated their claim that Mr. Penley spent more time during 2012 in his real

estate activities than in his employment with HSS, as required by section

469(c)(7)(B)(i). See Merino v. Commissioner, at *8-*12. Accordingly, we hold

that petitioners have not demonstrated that Mr. Penley was a real estate

professional for 2012.

III. Mortgage Insurance Premiums

      At trial petitioners asserted they are entitled to additional deductions for

mortgage insurance premiums of $2,602 and $1,821 for the taxable years 2011 and

2012, respectively. It appears as we review the record that these mortgage

insurance premiums were in fact deducted on HHI’s tax returns for both years, and
                                        - 16 -

[*16] respondent did not dispute those deductions in his notice of deficiency. We

therefore find that petitioners are not entitled to additional deductions for those

amounts.

IV. Accuracy-Related Penalty

      The Commissioner bears the burden of production with respect to the

section 6662(a) accuracy-related penalty. See sec. 7491(c); Higbee v.

Commissioner, 116 T.C. 438, 446-447 (2001). In order to meet the burden of

production under section 7491(c), the Commissioner need only make a prima facie

case that imposition of the penalty is appropriate.

      Section 6662(a) imposes an accuracy-related penalty equal to 20% of the

portion of an underpayment of tax to which the section applies. Respondent

asserts that petitioners’ 2012 underpayment was attributable to negligence or

disregard of rules and regulations. See sec. 6662(b)(1).

      Negligence includes any failure to make a reasonable attempt to comply

with the provisions of the Code, including any failure to keep adequate books and

records or to substantiate items properly. See sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. Respondent has met his burden of production by showing that

Mr. Penley was not a real estate professional for 2012 as claimed on petitioners’
                                        - 17 -

[*17] return. Petitioners bear the burden of proving a defense to the penalty. See

Higbee v. Commissioner, 116 T.C. at 447.

      There is an exception to the section 6662(a) penalty when a taxpayer can

demonstrate that the taxpayer (1) had reasonable cause for the underpayment and

(2) acted in good faith with respect to the underpayment. Sec. 6664(c)(1); sec.

1.6664-4(a), Income Tax Regs. A determination of whether a taxpayer acted with

reasonable cause “is made on a case-by-case basis, taking into account all

pertinent facts and circumstances.” Sec. 1.6664-4(b), Income Tax Regs. The most

important factor “is the extent of the taxpayer’s effort to assess the taxpayer’s

proper tax liability.” Id. Circumstances indicating that a taxpayer acted with

reasonable cause and in good faith include “an honest misunderstanding of fact or

law that is reasonable in light of all of the facts and circumstances, including the

experience, knowledge, and education of the taxpayer.” Id.

      Reliance on the advice of a tax professional may, but does not necessarily,

establish reasonable cause and good faith for the purpose of avoiding a section

6662(a) penalty. Sec. 1.6664-4(b)(1), Income Tax Regs.; see also United States v.

Boyle, 469 U.S. 241, 251 (1985) (reliance on an accountant or attorney as to a

matter of tax law may be reasonable); Canal Corp. v. Commissioner, 135 T.C. 199,

218 (2010) (“The right to rely on professional tax advice, however, is not
                                        - 18 -

[*18] unlimited.”). To avoid liability for a section 6662(a) penalty on the basis of

reliance on a tax professional, a taxpayer must show that “(1) [t]he adviser was a

competent professional who had sufficient expertise to justify reliance, (2) the

taxpayer provided necessary and accurate information to the adviser, and (3) the

taxpayer actually relied in good faith on the adviser’s judgment.” Neonatology

Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d

Cir. 2002); see also Charlotte’s Office Boutique, Inc. v. Commissioner, 425 F.3d

1203, 1212 n.8 (9th Cir. 2005) (quoting with approval the above three-prong test),

aff’g 121 T.C. 89 (2003). In addition, “the advice must not be based on

unreasonable factual or legal assumptions (including assumptions as to future

events) and must not unreasonably rely on the representations, statements,

findings, or agreements of the taxpayer or any other person”. Sec.

1.6664-4(c)(1)(ii), Income Tax Regs.

      The fact that petitioners had a professional prepare their returns does not, in

and of itself, prove that they acted with reasonable cause and in good faith. See

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99-100. Without

deciding whether petitioners’ chosen tax adviser was competent so as to justify

reliance, we observe that petitioners’ tax adviser evidently relied on their

representation that they worked some 2,520 hours in their real estate activities
                                         - 19 -

[*19] during the taxable year 2012. Petitioners provided a very liberal estimate of

their hours to their tax return preparer, and so they cannot shift to their preparer

responsibility for the returns that were prepared on the basis of that apparent

exaggeration. See sec. 1.6664-4(c)(1)(i), (ii) Income Tax Regs. Petitioners have

not proven reasonable cause for their underpayment. Thus, this Court concludes

petitioners are liable for the section 6662(a) accuracy-related penalty for 2012.

      To reflect the foregoing,


                                                  Decision will be entered under

                                            Rule 155.
