                  T.C. Summary Opinion 2011-22



                     UNITED STATES TAX COURT



    TODD D. BAILEY, JR. AND PAMELA J. BAILEY, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 28706-09S.                 Filed March 2, 2011.


     Kurt C. Swainston, for petitioners.

     Eugene Kim, 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.

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
                                 - 2 -

Revenue Code (Code) in effect for the year in issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

     Respondent determined a $19,358 deficiency in petitioners’

Federal income tax for 2004.     After stipulation, the sole issue

for decision is whether for 2004 petitioners are entitled to

deduct a net loss of $16,822 from two single-family rental

properties that they owned.

                              Background

I.   General Background

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.     Petitioners resided in

California at the time the petition was filed.     Petitioner

husband worked as an emergency physician during 2004.     His income

and deductions are not at issue except to the extent that his

2004 earnings of $212,200 caused the couple to encounter an

itemized deduction phaseout with respect to their 2004 Federal

income tax return.

     During 2004 petitioner wife (petitioner) did not earn a

salary.   Instead, she operated three rental properties that the

couple owned jointly.     Petitioner’s father was a builder.    Her

mother worked with her father as a bookkeeper and an interior

decorator.   This upbringing gave petitioner an “eye” for the

housing market, and experience with building codes, architectural
                                - 3 -

plans, and subcontractors.   Beginning around 1980 and using

mortgage financing and joint funds with petitioner husband,

petitioner continuously was in the market to purchase property

with potential for either resale or conversion into income-

producing property.

      Following this pattern, during 2004 petitioner negotiated

the purchase of a fourth single-family rental property and

researched a number of other potential single-family rental

property acquisitions.   Below is a detailed description of

petitioner’s rental real estate activities for 2004.    Petitioner

husband did not participate in the rental activities during the

year.

II.   Petitioner’s Rental Real Estate Activities for 2004

      A.   The Inn on Alisal Road

           1.   Description of the Property

      One of petitioners’ rental properties was on Alisal Road,

about 6 or 7 miles from the couple’s home.    They purchased the

property in 2000.   The structures consisted of a 1,200-square-

foot, two-bedroom, 3/4-bath (no tub) front house, built in 1949

or 1950, and a smaller back unit that had been converted from a

one-car garage into a separate residential dwelling.
                                 - 4 -

     Petitioner named this combined property “The Inn on Alisal

Road” (Inn).     As the name indicates, petitioner furnished the two

units and offered them together or separately for short-term rent

to overnight lodgers, usually for about 3 days at a time.

Petitioner provided a coffeemaker and coffee, but guests were

responsible for their own meals.    Typical guests were repeat

customers, most often couples or small groups, who were in town

for a wedding or other special occasion.       Petitioner rented the

Inn for 48 nights in 2004, with no guests in January and

February.    June was the most active month with guests on 12

nights.   Petitioner usually charged $200 or $250 per night.      She

did not record the guest names in a bookkeeping journal she

maintained in which she listed her receipts for the Inn by date

for 2004.

            2.   Petitioner’s Activities

     Petitioner did not employ a management company.       Instead,

she operated the Inn herself.

     Petitioner’s onsite tasks included meeting potential guests

and cleaning the interior:    Dusting, vacuuming, washing sheets,

ironing, and running water to maintain the plumbing during

periods when the Inn was inactive.       Petitioner also maintained

the exterior, including gardening, hand watering the roses,

caring for a plum tree and two cherry trees, inspecting the water

drip irrigation system, taking out trash, reviewing the work of a
                               - 5 -

lawn service, and periodically cleaning leaves out of the

gutters.   On average during 2004, for the two units combined,

petitioner spent 5 hours per week on the interior and exterior

maintenance of the Inn, for a total of 260 hours for the year.1

     Petitioner also worked offsite with respect to the Inn.     She

would deposit guest payments at her bank.   She received telephone

calls inquiring about the Inn and calls for reservations.   She

paid bills and reconciled the bank account.   On occasion, she

would wash and iron the Inn’s linens in her large-capacity washer

and dryer at home.   She went to hardware and home improvement

stores to buy replacement items, such as light bulbs, a new

showerhead, and a new telephone.   On average, she spent 5 hours

     1
      For reasons explained in the discussion section below, the
number of hours petitioner spent on her rental property
activities is an important factor in the outcome of this case.
Petitioner did not maintain a log for 2004. The regulations do
not allow a postevent “ballpark guesstimate”. Hill v.
Commissioner, T.C. Memo. 2010-200; Carlstedt v. Commissioner,
T.C. Memo. 1997-331; Speer v. Commissioner, T.C. Memo. 1996-323;
Goshorn v. Commissioner, T.C. Memo. 1993-578. A log is not
required, however, and an individual may establish the extent of
participation in an activity by any reasonable means. Hill v.
Commissioner, supra; sec. 1.469-5T(f)(4), Temporary Income Tax
Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). In support of
petitioner’s testimony, the Court received into evidence lease
agreements, mortgage and closing agreements, attorney time
records, litigation documents, copies of correspondence, rental
car and airline receipts, third-party confirmation from a real
estate agent, photographs, and other corroborating documents.
Respondent did not challenge the time estimates for particular
tasks. Accordingly, we base our findings for hours on this
evidence, which was credible, even seemingly understated at
points, but bearing against petitioner for inexactitudes of her
own making. See Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir.
1930).
                                  - 6 -

per month offsite related to the Inn, for a total of 60 hours for

the year.

       Petitioner spent 4 hours during the year refinancing the

property.    She secured a variable-rate equity loan of $220,250,

initially at 5.640 percent.      She used the proceeds in main part

to extinguish a 10-percent fixed rate seller-financed mortgage.

            3.   Summary of Time Spent

       Below is a summary of petitioner’s hours with respect to the

Inn.

                     Activity                         Hours

       Interior and exterior maintenance               260
       Offsite supply purchases and banking             60
       Refinancing the mortgage                          4
         Total for the Inn                             324

            4.   Profitability

       For the year, petitioner incurred a net loss on the Inn of

$20,683.    The loss consisted of $10,680 in guest receipts offset

by $31,363 in expenses.    Interest payments on first and second

mortgages, depreciation, and property taxes were her largest

expenses.

       B.   The Second Street Property

            1.   Description of the Property

       A second of petitioners’ rental properties was on Second

Street (Second Street property), about two blocks from the Inn.

Petitioners purchased the property in 2000 for $292,000.      Similar

to the Inn, the property included two structures.     The front unit
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was a 1,149-square-foot, three-bedroom home, with 1-3/4 baths.

The back unit was a one-car garage that petitioner converted in

2002 into a small residence with a three-quarter bath and a

kitchenette.

          2.   Petitioner’s Activities

     As with the Inn, petitioner managed the Second Street

property personally and did not employ a management company.    In

contrast to the short-term guests at the Inn, petitioner sought

year-to-year tenants for the Second Street units.

                a.   Both Units

     Because petitioner sought long-term tenants, she did not

have interior duties at the Second Street property to the extent

she had with the Inn.   Her exterior responsibilities, however,

were similar, including testing the water drip irrigation system,

gardening, caring for an apricot tree and a large oak tree, and

reviewing the work of a lawn service.     She spent 3 hours a week

on exterior maintenance for a total of 156 hours for the year.

     Petitioner had routine offsite financial recordkeeping

duties similar to those with the Inn.     She would spend 3 hours a

month depositing the monthly rent payment at her bank, paying

bills from her home, and reconciling the bank account, for a

total of 36 hours for the year.
                                 - 8 -

                 b.   Back Dwelling

     During 2004 petitioner rented the back unit for $1,100 per

month.    Her tenant had continued the lease from 2003 but did not

renew in 2004 after a sewer backup problem.    Petitioner spent a

total of 20 hours during the year overseeing a plumbing

contractor to correct the problem and cleaning the unit.     Within

2 months, petitioner was able to find a new tenant for the same

$1,100 monthly rent.    She spent 10 hours during 2004 searching

for the new tenant, showing the unit, and executing the new lease

agreement.

                 c.   Front Dwelling

     Unusual circumstances with respect to the front unit caused

petitioner to spend extra time with respect to the Second Street

property during 2004.    By late 2000 petitioner’s tenants in the

front house noticed a mildew problem.    The tenants moved out.

They turned out to be petitioner’s last tenants in the front

unit.    As petitioner began stripping away layers of linoleum to

determine the extent of the mildew problem, she discovered that

black mold was present throughout the entire underpinning of the

home.    By the end of 2001 petitioner was “at wits’ end”.   She

eventually discovered that an earlier inspector had determined

that the home has insufficient subvents.    In addition, a prior

owner built an addition that blocked some of the existing

subvents.    Further, the El Nino storm of 1997-98 soaked the
                               - 9 -

carpets, flooring, and walls, compounding the problem.    The toxic

mold infestation was so bad that petitioner was unable to provide

a warranty of habitability to any prospective tenant.

     In 2002 petitioners engaged an attorney to sue the prior

owner and the owner’s son-in-law.   The son-in-law served as the

agent for the seller (his mother-in-law) and for the buyer

(petitioners).   Petitioners claimed in main part that the prior

owner and the son-in-law knew about the mold problem and did not

tell them.   Petitioners also named as defendants a business that

performed the home inspection for their purchase and a pest

control contractor that petitioner paid annually to inspect the

home for termites.

     During 2003 petitioner learned that even if they won the

case, they might not be able to collect the judgment if the

defendants did not have sufficient assets.   Petitioner hired a

private investigator to search for assets.   During 2004,

petitioner spent 30 hours conducting Internet research to assist

the private investigator.

     Petitioner paid her attorney $70,109 during 2004 for his

work on the lawsuit.   During the year, petitioner spent 15 hours

periodically discussing the litigation with the attorney and

reviewing documents that he sent to her.   She also spent 5 hours

coordinating with the attorney to determine whether the
                               - 10 -

homeowner’s policy covered any part of the loss.    The insurance

company denied coverage.

     In 2004 the pest control contractor settled its liability

for $50,000.    The home inspection business also settled, but the

settlement amount is not in the record.    Following a nonjury

trial in January 2005, the Superior Court of the State of

California, County of Santa Barbara, awarded petitioners

$135,303.81 in damages from the prior owner for “breach of

contract” and the same amount in damages from the prior owner’s

son-in-law for “professional negligence”.    In addition, the court

awarded petitioners recovery of attorney’s fees and costs.

     Petitioner spent further time in 2004 on other activities

related to the front unit.   First, because the home was vacant,

she would spend an hour per week in the interior cleaning,

dusting, and in maintaining the plumbing, for a total of 52 hours

for the year.

     Second, she spent 24 hours in 2004 planning how she would

renovate the home after she received the litigation proceeds and

after contractors finished gutting the interior to remove the

mold and to install proper venting.     She met with representatives

of the town’s building department, and she drafted plans to

redesign the interior.   For example, she decided to remove a wall

between the kitchen and the dining room to create an open floor

plan.
                               - 11 -

     Third, petitioner spent 10 hours during the year driving to

hardware and paint stores to buy supplies and working with movers

to bring items from storage to the property.

          3.   Summary of Time Spent

     The following is a summary of petitioner’s hours for 2004

with respect to her activities for the Second Street property.

         Combined for Both Units                    Hours

     Exterior maintenance                            156
     Offsite bill paying and banking                  36
       Subtotal                                      192

          Back Unit Only                            Hours

     Correct and clean sewer backup                   20
     Search and lease for new tenant                  10
       Subtotal                                       30

          Front Unit Only                           Hours

     Asset investigation research                     30
     Litigation monitoring and support                15
     Insurance coverage inquiries                      5
     Interior maintenance                             52
     Renovation planning                              24
     Supplies purchases and movers                    10
       Subtotal                                      136

         Grand total for the Second St. property     358

          4.   Profitability

     Petitioner incurred an operating loss of $17,167 related to

the Second Street property for 2004.    The loss consisted of

$11,000 in rent she collected on the back unit minus $28,167 in

operating expenses related to both units.    Mortgage interest,

depreciation, supplies, and property taxes were the largest
                                - 12 -

expenses.    As noted above, petitioner also expended $70,109 in

2004 for attorney’s fees related to the mold litigation for the

front unit.

     C.     The Existing Boise Property

            1.   Description of the Property

     The third of petitioners’ rental properties was on Rose Hill

Street, Boise, Idaho (existing Boise property).       Petitioner

became interested in Boise because she found that she liked the

area from visiting a brother living there and a great uncle who

lived nearby.    The record is sparse about this property, other

than that it was a single-family home that petitioner purchased

in an earlier year and which one tenant or family rented for all

of 2004.

            2.   Petitioner’s Activities

     Petitioner operated the existing Boise property directly and

did not employ a management company.       For 2004 petitioner’s

duties consisted solely of spending 2 hours per month, for a

total of 24 hours for the year, depositing to her bank account

the monthly rent check she received by mail, paying from her home

occasional bills such as the annual water bill and a one-time

special sewer connection charge, and reconciling the bank

account.    No extraordinary events occurred during 2004 that

required additional time.
                                - 13 -

           3.   Summary of Time Spent

                    Activity                         Hours

     Bill paying and banking                           24
       Total for existing Boise property               24

           4.   Profitability

     Petitioner earned a profit of $345 related to the existing

Boise property for 2004.   The profit consisted of $6,000 in rent

she received minus $5,655 in expenses.    Mortgage interest,

property taxes, and depreciation were the largest expenses.

     D.    New Acquisition in Boise

           1.   Description of Property

     On August 25, 2004, petitioner paid $185,000 to acquire

another one-story single-family home in Boise, on a 3/4-acre lot,

also located on Rose Hill Drive (new acquisition in Boise).     She

financed the purchase with a $166,315 mortgage and joint funds.

The house, built in 1941, is a “darling” home with a wood burning

fireplace, crown molding, and a brick exterior made with “clinker

bricks”.   The main floor contains two bedrooms, one bathroom, and

a small kitchen.   Prior owners had converted the basement into an

apartment for a person who took care of the owner.    Petitioner

did not begin renting the home to tenants in 2004.

           2.   Petitioner’s Activities

     Petitioner first found the new acquisition in Boise in April

2004 on the Internet.   She researched the property online before

contacting the seller’s real estate agent.    After a week of
                               - 14 -

telephone discussions and emails with the agent, petitioner made

a formal offer for the property.    Her total time through

extending the offer was 10 hours.

       The 20 weeks from her escrow deposit to closing was

unusually time consuming for petitioner because she had not

previously purchased a home from a “short sale”.    Petitioner’s

questions about zoning and the purchase difficulties caused her

to speak weekly with the selling realtor.    These discussions

totaled 2.5 hours per week for a sum of 50 hours over the 20-week

escrow period.

       Petitioner also made numerous calls to representatives of

the seller’s bank, which was controlling the sale.    In addition,

petitioner spoke a number of times with a Boise representative of

her own bank regarding mortgage terms.    Her discussions with

bankers totaled 10 hours during the year.

       Petitioner flew round trip to Boise on August 11, 2004, for

a walkthrough inspection of the house before closing.    She left

her home around 5:15 a.m., drove to the Los Angeles airport

(LAX), flew to Boise, rented a car, completed the inspection,

returned to the Boise airport, dropped off the rental car, flew

back to LAX, and arrived at about 8:15 p.m. at the LAX parking

lot.    She drove to her parents’ home nearby for the night,

returning to her own home the next morning.    In combination with
                                  - 15 -

making airline and rental car reservations, petitioner devoted 25

hours to inspecting the new acquisition in Boise.

     Petitioner also spent 10 hours related to the closing

agreement and to planning future remodeling of the property.

           3.     Summary of Time Spent

                      Activity                        Hours

     Pre-offer research, emails, and calls              10
     Discussions with realtor during escrow             50
     Discussions with banker                            10
     Round-trip to Boise for walkthrough                25
     Closing and renovation planning                    10
       Grand total for new acquisition in Boise        105

           4.     Profitability

     Petitioner did not have income and did not report her

expenses related to the new acquisition in Boise for 2004.

     E.    Research of Other Potential Acquisitions

           1.     Description of Property

     Petitioner researched other properties for potential

acquisition in certain real estate markets that she found

promising.      She particularly focused on houses in Boise; the

Brentwood section of Los Angeles; San Fernando Valley,

California; Santa Ynez Valley, California; and Sherman Oaks,

California.

           2.     Petitioner’s Activities

     Petitioner conducted her research on potential acquisitions

primarily over the Internet.      She would peruse real estate Web

sites.    During 2004, on 3 days each week petitioner spent an hour
                                  - 16 -

conducting her Internet research, totaling 156 hours for the

year.     For locations nearby she would drive through the areas to

assess houses and the local market.        Her monthly research drives

through neighborhoods would take 3 hours for a total of 36 hours

for the year.

             3.   Summary of Time Spent

                      Activity                          Hours

        Internet research                                156
        Driving investigation of neighborhoods            36
          Grand total for research of other
            potential acquisitions                       192

             4.   Profitability

        Petitioner did not receive any income and did not keep

records of the expenses related to her investigation of potential

property purchases in 2004.

III. Summary of Petitioner’s Time With Respect to All of the
     Rental Income Properties for 2004

        Below is a summary of the time petitioner spent with respect

to all of her rental income properties for 2004.

                      Activity                          Hours

        The Inn on Alisal Road                           324
        The Second Street property                       358
        The existing Boise property                       24
        The new acquisition in Boise                     105
        Researching potential acquisitions               192
          Grand total for all properties               1,003

        Less time spent on the Inn (see below)          (324)
          Total hours excluding the Inn                  679
                                 - 17 -

IV.   Procedural Posture

      Petitioners engaged Benadon, Shapiro, Villalobos, C.P.A.s,

of Burbank, California, to prepare their 2004 Federal income tax

return.   Although the return encompassed 39 pages, relevant here

are solely two items:      (1) Petitioners deducted a loss of $20,683

from the Inn, which they reported on Schedule C, Profit or Loss

From Business; and (2) petitioners deducted a loss of $86,931

from the other two rental properties, which they reported on

Schedule E, Supplemental Income and Loss.     The Schedule E loss

consisted of three components:     (1) The $17,167 operating loss on

the Second Street property; (2) the $70,109 in attorney’s fees

for the Second Street property; and (3) the $345 profit on the

existing Boise property.     Petitioners did not report any income

or expenses related to the new acquisition in Boise or from

petitioner’s general research into other potential real estate

acquisitions.

      Respondent selected petitioners’ 2004 Federal income tax

return for examination.     Respondent allowed the $20,683 Schedule

C loss for the Inn.   In a notice of deficiency, however,

respondent disallowed the $70,109 in attorney’s fees related to

the Second Street property, determining that the fees were not a

currently deductible ordinary and necessary business expense.

Respondent also disallowed the remaining Schedule E loss of

$16,822, consisting of the $17,167 loss on the Second Street
                              - 18 -

property offset by the $345 profit on the existing Boise

property.   Respondent determined that the $16,822 net loss was a

passive activity loss that was not currently deductible for 2004.

     The disallowances caused an increase to petitioners’

adjusted gross income (AGI), which in turn caused a computational

phaseout of $1,466 of their itemized deductions.    The adjustments

and phaseout resulted in a Federal income tax deficiency of

$19,358 for 2004.

     Petitioners contested the adjustments in a petition to this

Court.   The parties stipulated that the $70,109 in attorney’s

fees was a capital expenditure that petitioners should add to the

basis of the Second Street property.     The stipulation left as the

sole disputed issue whether petitioners may deduct the remaining

Schedule E net loss of $16,822.

                            Discussion

I.   Burden of Proof

     In general, the Commissioner’s determination set forth in a

notice of deficiency is presumed correct, and the taxpayer bears

the burden of showing that the determination is in error.    Rule

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

are a matter of legislative grace.     Deputy v. du Pont, 308 U.S.

488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435,

440 (1934).   A taxpayer bears the burden of proving entitlement

to any deduction claimed.   Rule 142(a); INDOPCO, Inc. v.
                              - 19 -

Commissioner, 503 U.S. 79, 84 (1992); Welch v. Helvering, supra;

Wilson v. Commissioner, T.C. Memo. 2001-139.

      Pursuant to section 7491(a), the burden of proof as to

factual matters shifts to the Commissioner under certain

circumstances.   Petitioners have neither alleged that section

7491(a) applies nor established their compliance with the

substantiation and recordkeeping requirements.    See sec.

7491(a)(2)(A) and (B).   Petitioners therefore bear the burden of

proof.   See Rule 142(a).

II.   Passive Losses in General

      Taxpayers may deduct ordinary and necessary expenses they

paid or incurred during the year in carrying on a trade or

business and for the production of income.    Secs. 162, 212.    The

Code, however, limits the deduction for losses arising from 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).   A rental activity is “any activity where payments are

principally for the use of tangible property.”    Sec. 469(j)(8).
                                - 20 -

III. Real Estate Professional

       A.   Exceptions to the General Rule

       There are two main exceptions to the general rule that

rental activities are per se passive activities.      Moss v.

Commissioner, 135 T.C. __, __ (2010) (slip op. at 6).        One

exception applies to rental real estate activities where the

individual actively participates in the activity during the year.

Sec. 469(i)(1); Moss v. Commissioner, supra at __ (slip op. at

10).    The maximum deductible loss under this first exception is

$25,000.    Sec. 469(i)(2).   The $25,000 loss allowance, however,

begins to phase out when AGI exceeds $100,000 and phases out

completely when AGI is $150,000 or more.     Sec. 469(i)(3)(A); Moss

v. Commissioner, supra at __ (slip op. at 10).      The stipulation

to capitalize the $70,109 in attorney’s fees increased

petitioners’ AGI from their reported figure of $104,637 to an

amount exceeding the $150,000 phaseout ceiling.     Consequently,

the active participation exception is not available to

petitioners.

       The other exception is the one in controversy here.      This

second exception is available to “taxpayers in real property

business” (real estate professionals).     Sec. 469(c)(7).    Rental

activities of a real estate professional are not per se passive

activities under section 469(c)(2).      Sec. 469(c)(7)(A)(i); Moss
                               - 21 -

v. Commissioner, supra at      (slip op. at 6); sec. 1.469-9(e)(1),

Income Tax Regs.

     To qualify as a real estate professional, a taxpayer must

satisfy both of the following requirements:

          (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.

Sec. 469(c)(7)(B).    For couples filing “a joint return, the

requirements of the preceding sentence are satisfied if and only

if either spouse separately satisfies such requirements.”       Id.

In other words, only one spouse needs to qualify as a real estate

professional to recharacterize an otherwise passive activity.

Moss v. Commissioner, supra at      (slip op. at 6-7).

     B.     Application of the 750-Hour Requirement to Petitioner

     Respondent does not dispute that petitioner satisfied the

first requirement of materially participating in the activities.

Among other qualifying factors, petitioner had no other vocation

during 2004 and her involvement in the properties was regular,

continuous, and substantial.   See sec. 469(h)(1); sec 1.469-

5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25,

1988).    Therefore, the only remaining issue is whether petitioner
                                - 22 -

performed more than 750 hours of services in “real property

trades or businesses” during 2004.

     To compute the 750 hours, the Code treats each real estate

activity as a separate activity unless the taxpayer makes an

election to combine some or all of the activities.     Sec.

469(c)(7)(A); Hill v. Commissioner, T.C. Memo. 2010-200; sec.

1.469-9(e)(1), Income Tax Regs.     An election is binding for the

year of election and for all future years in which the taxpayer

qualifies.    Sec. 1.469-9(g), Income Tax Regs.   Respondent does

not contend that petitioners failed to elect to combine all of

their rental properties as one activity.     Accordingly, we deem

that issue conceded.     See Moss v. Commissioner, supra at __ (slip

op. at 7).

     Respondent does contend, however, that the Inn is not a

“real property trade or business” for purposes of the 750-hour

test.   The significance of respondent’s contention is that if

petitioner can include the hours she spent on the Inn, then she

easily satisfies the 750-hour requirement because she spent 1,003

hours on all of her rental activities for the year.     If, on the

other hand, she cannot include the hours relating to the Inn,

then she spent only 679 hours on her real estate activities.     See

table supra    p. 16.   She would not satisfy the 750-hour

requirement, she would not qualify as a real estate professional,

the two rental properties at issue would be per se passive
                              - 23 -

activities, and as a result the $16,822 net loss would not be

deductible in 2004.

     C.   The Parties’ Contentions

     Petitioner points to the plain language of section

469(c)(7)(C) and its legislative history2 to contend that

congressional intent and the statute itself clearly allow her to

include her hours from her activities for the Inn.    The statute

describes a “real property trade or business” as “any real

property development, redevelopment, construction,

reconstruction, acquisition, conversion, rental, operation,

management, leasing, or brokerage trade or business.”      Id.

(emphasis added by petitioner).

     Respondent counters by pointing to a regulation that

provides the following exclusion:    “an activity involving the use

of tangible property is not a rental activity” for a year if,

among other reasons, “the average period of customer use for such

property is seven days or less” during the year.    Sec.

1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs., 53 Fed. Reg.

5702 (Feb. 25, 1988).   The parties agree that the average period

of the guests’ use of the Inn in 2004 was 3 days.    Therefore,

respondent contends that for passive activity purposes for 2004,

petitioner must separate the hours spent on and the loss from the



     2
      Petitioner refers to H. Rept. 103-111, at 613-614 (1993),
1993-3 C.B. 167, 189-190.
                                - 24 -

Inn from her other rental real estate activities hours and net

loss.

     D.      The Court’s Prior Opinion in Bailey

        To support his position, respondent points to an opinion of

this Court, Bailey v. Commissioner, T.C. Memo. 2001-296 (no

relation to petitioners), which involved a similar set of facts.

Because petitioner also focuses on the Bailey opinion, we detail

below the facts and holding of that case.

        In Bailey the taxpayers, husband and wife, were licensed

attorneys.     In 1997, the pertinent year at issue, they also owned

and taxpayer wife (taxpayer) participated in the operation of

five real estate properties at three locations:     (1) The Lake

Arrowhead property (a single-family house); (2) the Indian Wells

properties (a condominium and a unit in a planned development);

and (3) the Elderwood properties (two four-plex buildings).       The

taxpayer also spent 104 hours on general real estate activities

not associated with any one particular property.     The taxpayer

rented the Lake Arrowhead property to customers in 1997 for

periods averaging less than 4 days.

        The taxpayers had made a previous election to group the

properties as one activity.     Each of the properties generated a

loss for 1997.     The taxpayers combined them and deducted the

losses on Schedule E of their 1997 Federal income tax return.
                               - 25 -

     The Commissioner determined that the taxpayer could not

combine her hours on the Lake Arrowhead property with her hours

on the other two rental properties because the rental period for

the Lake Arrowhead property was less than the 7-day threshold of

section 1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs., supra.

Accordingly, the Commissioner disallowed the taxpayers’ losses

from all three of their rental properties.

     Specifically with respect to disallowing the loss from the

Lake Arrowhead property, the Commissioner determined that the

taxpayer did not establish that she materially participated in

operating the property in part because she engaged a management

company to operate the property and in part because she had

significant outside activities as an attorney.   Pertinent here,

the Commissioner also disallowed the losses on the taxpayer’s

other two rental properties because the taxpayer did not

establish that she expended more than 750 hours of personal

services on these other two properties, including her time on

general rental real estate activities but excluding her time on

the Lake Arrowhead property.

     The taxpayer contended that she qualified as a real estate

professional for 1997 because when she included the Lake

Arrowhead property, she met the two requirements of section

469(c)(7)(B); namely:   (1) She performed more than one-half of

her personal services for the year in real property trades or
                               - 26 -

businesses; and (2) she performed more than 750 hours in real

property trades or businesses in which she materially

participated.   Therefore, according to the taxpayer, she and her

husband were entitled to deduct the losses from all of their

rental properties because she was a real estate professional for

the year.

     The Court sustained the Commissioner’s disallowance of all

of the taxpayers’ rental real estate losses for 1997 because:

(1) The taxpayer did not materially participate in the Lake

Arrowhead property; and (2) relevant here, after excluding the

taxpayer’s time on the Lake Arrowhead property because of its

short--less than 7 days--average rental period, the taxpayer did

not have more than 750 hours in personal services on the other

properties to qualify as a real estate professional.     In summary,

the short rental period made the Lake Arrowhead property a trade

or business, not a rental real estate activity.

     E.     Applying Bailey to Petitioner’s Facts and Circumstances

     Petitioner distinguishes her facts and circumstances from

those of the taxpayer in Bailey.    Petitioner emphasizes that she

materially participated in the operation of the Inn, a point with

which respondent agrees, whereas the taxpayer in Bailey did not

materially participate in the operation of the Lake Arrowhead

property.    From petitioner’s viewpoint, her material

participation in the Inn in 2004, in combination with the clear
                              - 27 -

and unambiguous plain language of section 469(c)(7)(C), requires

the inclusion of the hours she spent operating the Inn for

purposes of the 750-hour test.   In other words, petitioner

contends that a taxpayer is entitled to include all real property

trades or businesses in which the taxpayer materially

participated during the year for purposes of computing the 750-

hour requirement for a real estate professional.   We disagree.

     The Court in Bailey addressed this exact issue, in two

portions of the opinion.   We quote extensively below from Bailey

to resolve any doubt.   The first excerpt below comes from the

portion of the opinion where the Court was deciding whether the

taxpayer met the 750-hour test to be a real estate professional,

as follows:

          Whether petitioner qualifies as a real estate
     professional under section 469(c)(7) is based on
     petitioner’s activities related to the Indian Wells
     condominium, Indian Wells unit, and Elderwood
     properties. Petitioners argue that the Lake Arrowhead
     property is rental real estate that should be included
     in determining whether petitioner is a real estate
     professional. We disagree.

          Petitioner’s activities that are related to the
     Lake Arrowhead property are disregarded for purposes of
     determining whether she was a real estate professional,
     because the Lake Arrowhead property is not “rental real
     estate” as defined in section 1.469-9(b)(3), Income Tax
     Regs. Section 1.469-9(b)(3), Income Tax Regs., defines
     “rental real estate” as “any real property used by
     customers or held for use by customers in a rental
     activity within the meaning of section 1.469-1T(e)(3).”
     Section 1.469-1T(e)(3), Temporary Income Tax Regs., 53
     Fed. Reg. 5702 (Feb. 25, 1988), states that, except as
     otherwise provided, an activity is a “rental activity”
     for a taxable year, if “during such taxable year,
                                - 28 -

     tangible property held in connection with the activity
     is used by customers or held for use by customers”.
     See also sec. 469(j)(8). As provided in section
     1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs.,
     supra, an “activity involving the use of tangible
     property is not a rental activity for a taxable year if
     for such taxable year * * * [the] average period of
     customer use for such property is seven days or less”.

          The average period of customer use for the Lake
     Arrowhead property was less than 7 days during 1996 and
     1997. Thus, the rental of the Lake Arrowhead property
     is not a “rental activity” as defined in section
     1.469-1T(e)(3)(ii)(A), Temporary Income Tax Regs.,
     supra, not “rental real estate” under section
     1.469-9(b)(3), Income Tax Regs., and not included in
     the election under section 469(c)(7) to treat all
     interests in rental real estate as a single rental real
     estate activity. See Scheiner v. Commissioner, T.C.
     Memo. 1996-554 (where average period of customer use
     less than 7 days, condominium hotel activity was not
     rental activity under section 469(j)(8) and not
     considered a passive activity under section 469(c)(2));
     Mordkin v. Commissioner, T.C. Memo. 1996-187.

     Accordingly, petitioner’s attempt to distinguish her

situation because she materially participated in operating the

Inn is misplaced.     Petitioner misapprehends the significance of

material participation.    As noted supra p. 20, material

participation is significant for determining whether a trade or

business is a passive activity.    For example, the taxpayer in

Bailey did not materially participate in operating the Lake

Arrowhead property.    Consequently, because the Lake Arrowhead

activity was not a rental activity under section 469(c)(2), but

rather a trade or business in which the taxpayer did not

materially participate under section 469(c)(1), the Lake

Arrowhead activity was a passive activity; and therefore the
                             - 29 -

Commissioner disallowed the losses.   As applied here, as noted

supra pp. 17-18, respondent allowed petitioner’s year 2004

Schedule C loss for the Inn because she materially participated

in the activity during the year.

     The above excerpt from Bailey illustrates this point.     When

a taxpayer spends time on a real estate property that the

taxpayer rents for periods averaging less than 7 days, that

property is no longer a “rental activity”.   Therefore, the

taxpayer must exclude or “disregard” the time he or she spent on

the property for purposes of counting hours for the 750-hour

section 469(c)(7)(B)(ii) test to be a real estate professional.

     Further, as if in anticipation of petitioner’s contentions,

the Court in Bailey, in a later portion of the opinion, stated

the following in discussing whether the taxpayer could separately

deduct the loss on the Lake Arrowhead property as a Schedule C

business loss:

          Petitioners argue that they properly filed an
     election pursuant to section 469(c)(7)(A)(ii) to treat
     all of their interests in rental real estate as a
     single rental real estate activity and that their
     activities related to the rental of their Lake
     Arrowhead property should be considered in aggregate
     with their other rental properties. As previously
     explained, petitioners’ argument fails because the
     election to treat all rental properties as one activity
     is limited to the purpose of determining whether a
     taxpayer is a real estate professional under section
     469(c)(7). Here, the average period of use of the Lake
     Arrowhead property was less than 7 days in 1996 and
     1997; thus, the rental of the Lake Arrowhead property
     is not a rental activity as defined in section
     469(j)(8) and is not a passive activity under section
                               - 30 -

     469(c)(2). See Scheiner v. Commissioner, supra;
     Mordkin v. Commissioner, supra. * * *

     We reiterate the holding in Bailey that a rental property

with average use of less than 7 days is not an activity that a

taxpayer can include in computing the more than 750 hours of

services that a taxpayer needs to qualify as a real estate

professional under section 469(c)(7)(B)(ii).

     The rationale for segregating petitioner’s hours is

consistent with the disparate reporting of the activities.      The

Inn activity is reported on Schedule C because managing a

property with a short rental period is akin to running a

business.    The other rental real estate activities are reported

on Schedule E as a separate and distinct activity and generally

fall within the purview of section 212.

     The statute’s legislative history reinforces this rationale,

though not as petitioner suggests.      A 1986 Senate Finance

Committee report, in explaining the then-new passive activity

loss rules, provided the following clarification:      “A passive

activity is defined under the bill to include any rental

activity, whether or not the taxpayer materially participates.

However, operating a hotel or similar transient lodging, for

example, where substantial services are provided, is not a rental

activity.”   S. Rept. 99-313, at 720 (1986), 1986-3 C.B. (Vol. 3)

1, 720.
                              - 31 -

IV.   Conclusion

      In summary, the 679 hours petitioner spent in 2004 on all of

her rental real estate activities excluding the Inn are not more

than the 750 hours that section 469(c)(7)(B)(ii) requires for

petitioner to qualify as a real estate professional.

Consequently, these other activities are per se passive under

section 469(c)(2).   We therefore sustain respondent’s

disallowance for 2004 of petitioners’ combined net loss of

$16,822 from their Second Street property and their existing

Boise property.

      We have considered all of petitioners’ contentions and

arguments that are not discussed herein, and we conclude they are

without merit, irrelevant, and/or moot.

      To reflect the foregoing,


                                          Decision will be entered

                                    under Rule 155.
