                  T.C. Summary Opinion 2004-112



                     UNITED STATES TAX COURT



   ALEXANDER FIRSOW AND CAMILLA THOMAS-FIRSOW, a.k.a. CAMILLA
                     THOMAS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 13284-02S.           Filed August 24, 2004.


     James D. McCarthy, Jr., for petitioners.

     Bradley C. Plovan, for respondent.


     PANUTHOS, Chief Special Trial Judge:   This case was heard

pursuant to the provisions of section 7463 of the Internal

Revenue Code in effect at the time the petition was filed.    The

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

this opinion should not be cited as authority.    Unless otherwise

indicated, subsequent section references are to the Internal

Revenue Code in effect for the years in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.
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     Respondent determined deficiencies and penalties in

petitioners’ 1999 and 2000 Federal income taxes as follows:

                                             Penalty
            Year        Deficiency         Sec. 6662(a)

            1999         $4,886               $977.20
            2000          5,642              1,128.40

The issues for decision are:      (1) Whether the passive activity

rules of section 469 preclude petitioners from deducting the full

amounts of losses from their rental real estate activities for

the 1999 and 2000 taxable years, and (2) whether petitioners are

liable for accuracy-related penalties for the 1999 and 2000

taxable years pursuant to section 6662(a).

Background

     Some of the facts have been stipulated, and they are so

found.   The stipulation of facts and the attached exhibits are

incorporated herein by this reference.      At the time their

petition was filed, petitioners resided in Abingdon, Maryland.

     During the years in issue, petitioners were employees of

Ashley, Inc., which is located in Havre de Grace, Maryland.

Petitioner Camilla Thomas-Firsow worked full time as an employee,

whereas petitioner Alexander Firsow (petitioner) worked 32 hours

per week.    In addition to being an employee of Ashley, Inc.,

petitioner also operated a horse racing business.

     Also during the years in issue, petitioners owned two rental

properties.    One was located at 309 Rowland Drive, Port Deposit,
                               - 3 -

Maryland (Port Deposit property).   The other was located at 2539

Harbor Lane, Sanibel, Florida (Sanibel property).

     The Sanibel property was rented for approximately 1 month

during 1999 and for approximately 3 weeks during 2000.   The Port

Deposit property was rented throughout 1999 and 2000. Petitioners

spent no more than 2 weeks per year at the Sanibel property,

performing maintenance work, but also fishing off the pier.

     Petitioners filed joint Federal income tax returns for the

1999 and 2000 taxable years.   For 1999, petitioners reported on

their Schedule E, Supplemental Income and Loss, a loss of $25,712

from rental real estate for the Port Deposit property and the

Sanibel property.   For 2000, petitioners reported a loss on

Schedule E of $29,493 for the same properties.

     For each of the taxable years, the Schedule E filed by

petitioners contained the following cautionary language:

“Caution:   Your rental real estate loss * * * may be limited.

See page E-3 to find out if you must file Form 8582.   Real estate

professionals must complete line 42 on page 2.”   Despite this

language, petitioners left blank line 42 of Schedule E, dealing

with “Reconciliation for Real Estate Professionals”.   Moreover,

petitioners did not file a Form 8582, Passive Activity Loss

Limitations, with either of their joint returns for 1999 and

2000.
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     On July 9, 2003, in response to an examination of their

returns, petitioners provided respondent a document entitled

“Election to Aggregate Activities” for the Port Deposit property,

Sanibel property, and other properties.      This election was not

filed with petitioners’ joint returns for 1999 and 2000.

         Respondent contends that petitioners are not entitled to

deduct the full amounts of losses associated with their rental

activity because of passive activity loss limitations under

section 469.1    Respondent further contends that petitioners are

liable for accuracy-related penalties under section 6662(a) due

to negligence or disregard of the rules or regulations.

Discussion

     Whether losses attributable to rental real estate activities

are deductible in full depends upon the classification of such

activities.     In general, a rental activity is a “passive

activity,” even if the taxpayer “materially participates” in such

activity.     Sec. 469(c)(2), (4).   The deductible amount of

aggregate losses from a rental activity for the taxable year is

thus limited to the aggregate income from all passive activities

for the corresponding year.     The excess, if any, of the losses

over the income is a “passive activity loss”.      Sec. 469(d)(1).

The passive activity loss is then disallowed as a deduction to



     1
        Respondent does not contest the amount of the reported
losses, but instead contests the extent to which petitioners are
entitled to deduct such losses.
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the extent that the taxpayer did not “actively participate” in

the rental real estate activity.   Sec. 469(a)(1), (i)(1).   In the

present case, respondent determined that petitioners actively

participated in their rental activity and thus are entitled to

deduct some, but not all, of their passive activity losses,

subject to the limitations under section 469(i).

     Petitioners, however, classify their rental activity

differently.   They contend that, during the taxable years in

issue, they were in the “real property trade or business” as that

term is defined under section 469(c)(7).   If they were, then the

passive activity loss limitations of section 469 would not apply,

and petitioners would be entitled to deduct the full amount of

their losses for each year.   See sec. 469(c)(7)(A)(i).

     Deductions are a matter of legislative grace, and generally

the taxpayer bears the burden of proving entitlement to any

deduction claimed.   Rule 142(a); INDOPCO, Inc. v. Commissioner,

503 U.S. 79, 84 (1992).   The burden of proof has not shifted to

respondent pursuant to section 7491(a).    While examination of the

tax returns in issue commenced after July 22, 1998, neither of

the parties has addressed the applicability of section 7491(a).

Petitioners have not offered any evidence that they satisfied any

of the criteria of section 7491(a)(2)(A) and (B).   Accordingly,

we conclude that the burden remains on petitioners to prove that

they were in the real property trade or business and that their
                                - 6 -

rental real estate activity is not a passive activity for the

1999 and 2000 taxable years.

     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.     Sec.

469(c)(7)(C).   A taxpayer may elect to treat all interests in

rental real estate as one activity.     Sec. 469(c)(7)(A); sec.

1.469-9(g)(1), Income Tax Regs.    Such election is made by filing

a statement with the taxpayer’s original income tax return for

the taxable year.    Sec. 1.469-9(g)(3), Income Tax Regs.

     To qualify for the election, the taxpayer must satisfy two

requirements.   First, more than one-half of the personal services

performed in trades or businesses by the taxpayer during such

taxable year must be performed in real property trades or

businesses in which the taxpayer materially participates.       Sec.

469(c)(7)(B)(i).    Second, such taxpayer must perform 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)(ii).    In the case of a joint

return, both requirements must be satisfied by the same spouse.

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

     Under both requirements, a taxpayer must materially

participate in a real property trade or business in order for the
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personal services provided by the taxpayer in that real property

trade or business to count.    See sec. 469(c)(7)(B); sec. 1.469-

9(c)(3), Income Tax Regs.   A taxpayer is treated as materially

participating in an activity only if the taxpayer is involved in

the operations of the activity on a basis which is regular,

continuous, and substantial.   Sec. 469(h)(1).    In determining

whether a taxpayer materially participates, the participation of

the taxpayer’s spouse is taken into account.     Sec. 469(h)(5).

The temporary Treasury regulations promulgated under section 469

provide:

          The extent of an individual’s participation in an
     activity may be established by any reasonable means.
     Contemporaneous daily time reports, logs, or similar
     documents are not required if the extent of such
     participation may be established by other reasonable
     means. Reasonable means for purposes of this paragraph
     may include but are not limited to the identification
     of services performed over a period of time and the
     approximate number of hours spent performing such
     services during such period, based on appointment
     books, calendars, or narrative summaries.

Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg.

5727 (Feb. 25, 1988); see also sec. 1.469-9(b)(5), Income Tax

Regs.   This Court has acknowledged that these temporary

regulations are somewhat ambivalent concerning the records to be

maintained by taxpayers, but we have held that the regulations do

not allow a post-event “ballpark guesstimate”.     Fowler v.

Commissioner, T.C. Memo. 2002-223; Goshorn v. Commissioner, T.C.

Memo. 1993-578.
                                - 8 -

     To establish the amount of time petitioners spent on their

rental real estate activities in the present case, petitioners

introduced a spreadsheet and a daily work log summarizing the

work activities they performed on a daily basis for the Sanibel

property and Port Deposit Property.     The daily work log was not

prepared contemporaneously as petitioners performed each

activity, but it was composed by petitioners in preparation for

an examination of their returns by respondent.     The spreadsheet

lists the following hours spent by petitioners at their rental

properties:

     Year     Port Deposit property     Sanibel property   Total

     1999             283                   606             889
     2000             311                   494             805

Petitioner testified that he worked 12 hours per day whenever he

was at the Sanibel property.   The spreadsheet also lists

petitioners’ time spent rendering personal services for their own

residence and for the properties owned by petitioner’s parents.

     Petitioners have not met their burden of proving that they

were in the real property trade or business and that their rental

real estate activity is not a passive activity for the 1999 and

2000 taxable years.   While petitioners did not file their

election to aggregate activities with their joint returns for

1999 and 2000, we need not decide whether we should look at the

total number of hours during each of these taxable years such

that petitioners spent 889 hours in 1999 and 805 hours in 2000.
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We find that their testimony, the spreadsheet, and the daily work

logs were not credible.   Petitioners were employees of Ashley,

Inc., where she worked full time and he worked 32 hours a week.

In addition to his employment at Ashley, Inc., petitioner also

operated a horse racing business.    Petitioners testified, and the

spreadsheet indicates, that they spent a fair amount of time

rendering personal services for their own residence and for the

properties owned by petitioner’s parents.     Even if we were to

accept as true petitioner’s testimony that he worked 12 hours per

day at the Sanibel property (above and beyond his time fishing

off the pier), petitioners spent no more than 2 weeks per year

there.   While petitioners have spent some time performing

personal services at their rental properties, we conclude that

such time falls short of the “more than 750 hours of services”

required under section 469(c)(7).    Accordingly, we sustain

respondent’s determination regarding this issue.

     The final issue is whether petitioners are liable for

accuracy-related penalties under section 6662(a) for the 1999 and

2000 taxable years.   An accuracy-related penalty “applies to any

portion of an underpayment of tax required to be shown on a

return” where such portion is attributable to negligence or

disregard of rules or regulations.     Sec. 6662(a) and (b)(1).    The

term “negligence” includes any failure to make a reasonable

attempt to comply with the provisions of the Internal Revenue
                                  - 10 -

Code.    Sec. 6662(c).   The term “disregard” includes any careless,

reckless, or intentional disregard.        Id.   Respondent has the

burden of production with respect to the accuracy-related

penalties.    See sec. 7491(c).

     The courts have refined the Code definition of negligence as

a lack of due care or failure to do what a reasonable and prudent

person would do under similar circumstances.         Allen v.

Commissioner, 925 F.2d 348, 353 (9th Cir. 1991), affg. 92 T.C. 1

(1989).    Treasury regulations further provide that negligence

includes any failure to exercise ordinary and reasonable care in

the preparation of a tax return, failure to keep books and

records, or failure to substantiate items properly.        Sec.

1.6662-3(b)(1), Income Tax Regs.        A return position that has a

“reasonable basis” as defined in the regulation is not

attributable to negligence.       Id.

     An exception to the section 6662 penalty applies when the

taxpayer demonstrates:     (1) There was reasonable cause for the

underpayment, and (2) the taxpayer acted in good faith with

respect to the underpayment.      Sec. 6664(c).2    Whether the

taxpayer acted with reasonable cause and in good faith is

determined by the relevant facts and circumstances on a

case-by-case basis.      See Stubblefield v. Commissioner, T.C. Memo.


     2
        This section may provide relief even if a return position
does not satisfy the reasonable basis standard. Sec. 1.6662-
3(b)(3), Income Tax Regs.
                              - 11 -

1996-537; sec. 1.6664-4(b)(1), Income Tax Regs.   “Circumstances

that may indicate reasonable cause and good faith include an

honest misunderstanding of fact or law that is reasonable in

light of all the facts and circumstances, including the

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

1.6664-4(b)(1), Income Tax Regs.   A taxpayer is not subject to

the addition to tax for negligence where the taxpayer makes

honest mistakes in complex matters, but the taxpayer must take

reasonable steps to determine the law and to comply with it.

Niedringhaus v. Commissioner, 99 T.C. 202, 222 (1992).     The most

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

the proper tax liability.   Stubblefield v. Commissioner, T.C.

Memo. 1996-537; sec. 1.6664-4(b)(1), Income Tax Regs.

     Respondent has met his burden of production with respect to

the accuracy-related penalties under section 6662(a).    The

returns filed by petitioners contained cautionary language that

they failed to heed.   Petitioners did not maintain records for

their rental real estate activity, but produced the spreadsheet

and daily work log only in response to an examination of their

returns by respondent.   Based upon these facts and circumstances,

we find that petitioners did not take reasonable steps to

determine the law and to comply with it.   Moreover, petitioners

have failed to demonstrate that there was reasonable cause and

that they acted in good faith.   Accordingly, we sustain
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respondent’s determination with respect to the accuracy-related

penalties under section 6662(a).

     Reviewed and adopted as the report of the Small Tax Case

Division.

     To reflect the foregoing,

                                         Decision will be entered

                                   for respondent.
