                               T.C. Memo. 2017-93



                         UNITED STATES TAX COURT



 PAUL MORRIS MCNALLY AND PATRICIA ANN MCNALLY, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 28293-11.                          Filed May 30, 2017.



      Paul Morris McNally and Patricia Ann McNally, pro sese.

      Erik W. Nelson and Catherine J. Caballero, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: Respondent issued a notice of deficiency to petitioners

determining deficiencies in income tax and accuracy-related penalties.1 After trial


      1
      Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the relevant years, and all Rule references are
                                                                       (continued...)
                                         -2-

[*2] Patricia McNally introduced Form 8857, Request for Innocent Spouse Relief,

requesting relief from joint and several income tax liability for the taxable years at

issue. Respondent conceded that Mrs. McNally is entitled to partial relief from

her joint 2008 and 2009 tax liabilities pursuant to section 6015(c) and full relief

from the remainder of those liabilities pursuant to section 6015(f), thereby

providing Mrs. McNally complete relief from her joint 2008 and 2009 tax

liabilities.

       The issues for decision are whether Paul McNally for tax years 2008-09

(taxable years at issue) is entitled to: (1) deductions claimed on Schedules E,

Supplemental Income and Loss, for rental real estate losses of $154,067 and

$117,712, respectively; (2) claimed charitable contribution deductions of $9,425

and $11,980, respectively; (3) deductions claimed on Schedules C, Profit or Loss

From Business, for travel expenses incurred in connection with a trade or business

of $7,268 and $7,319, respectively; (4) deductions claimed on Schedules C for car

and truck expenses incurred in connection with a trade or business of $7,235 and

$8,132, respectively; and (5) deductions claimed on Schedules A, Itemized

Deductions, for job expenses and certain miscellaneous deductions of $3,863 and

       1
        (...continued)
to the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
                                         -3-

[*3] $13,874, respectively.2 We also decide whether Mr. McNally is liable for

section 6662(a) accuracy-related penalties for the taxable years at issue.

                                FINDINGS OF FACT

      On December 5, 2013, the Court’s order to show cause was made absolute,

and, under Rule 91(f)(3), the facts and exhibits set forth in respondent’s proposed

stipulation of facts were deemed stipulated. On May 2, 2016, the parties executed

a first supplemental stipulation of facts. Respondent’s proposed stipulation of

facts, the first supplemental stipulation of facts, and the attached exhibits are

incorporated herein by this reference. Petitioners resided in California when the

petition was filed.

      Petitioners filed joint Federal income tax returns for the taxable years at

issue and attached Schedules C to their 2008 and 2009 tax returns on which they

claimed deductions of $7,235 and $8,132 for car and truck expenses, respectively,

and $7,268 and $7,319 for travel expenses, respectively. Petitioners also attached

Schedules E to their 2008 and 2009 tax returns and listed eight and six rental

properties, respectively, but they did not file a statement with their 2008 or 2009

      2
       A number of computational issues arise from our decisions of the
aforementioned issues, including whether Mr. McNally is entitled to the claimed:
(1) deduction for tuition and fees for 2008, (2) itemized deductions for 2008 and
2009, (3) personal exemptions for 2008, (4) recovery rebate credit for 2008, and
(5) making work pay credit for 2009.
                                           -4-

[*4] return electing to treat all interests in rental real estate as a single rental real

estate activity. Petitioners claimed on Schedules E rental real estate loss

deductions of $154,067 and $117,712 for 2008 and 2009, respectively.

       During the taxable years at issue Mr. McNally was a full-time junior high

school teacher for the Vallejo City Unified School District. Mr. McNally was not

a licensed real estate broker or salesperson in either California or Washington

during the taxable years at issue, and he was not engaged in the trade or business

of real estate brokerage during the taxable years at issue. Petitioners introduced a

journal to substantiate their claimed hours worked in real property trades or

businesses (including their rental real estate activities), their car and truck

expenses, and their travel expenses. Petitioners’ journal repeatedly lists hours

spent “in the office” on real estate “stuff”. The journal indicates that petitioners

took numerous trips to their rental properties over the taxable years at issue;

however, it does not list the amount of time attributable to rental real estate

activities or the type of work completed. The journal sporadically lists purported

mileage driven, identified by “= RE”, but does not credibly establish that mileage

is attributable to any business use. Petitioners’ journal is not credible

substantiation of the amount of time attributable to rental real estate activities or
                                         -5-

[*5] real property trades or businesses or of petitioners’ reported car and truck

expenses or travel expenses.

      Petitioners attached Schedules A to their 2008 and 2009 tax returns on

which they claimed charitable contribution deductions of $9,425 and $11,980,

respectively, and job expense deductions and certain miscellaneous deductions of

$3,863 and $4,366, respectively. Petitioners introduced a Vehicle/Vessel Transfer

and Reassignment Form (vehicle transfer form) and a Form 8283, Noncash

Charitable Contributions, to substantiate their 2009 donation of a 1987 Toyota

Camry. Neither form, however, includes the amount of the donation--the vehicle

transfer form shows the amount of the donation as “donation”, and the Form 8283

does not show the fair market value of the donation. Additionally, petitioners

introduced a Solano County Superintendent of Schools--Leave and Earnings

Statement showing $92 and $91 of Vallejo Educational Association monthly union

dues for April 2008 and June 2009, respectively.

      On September 12, 2011, respondent sent petitioners a notice of deficiency

for the taxable years at issue that disallowed petitioners’ claimed rental real estate

loss deductions because respondent determined that petitioners’ rental real estate

activities were passive activities in the context of section 469. The notice of

deficiency also disallowed petitioners’ claimed Schedule C deductions for travel
                                         -6-

[*6] expenses and car and truck expenses, charitable contribution deductions, job

expense deductions and certain miscellaneous deductions and determined that they

are liable for section 6662(a) accuracy-related penalties for both 2008 and 2009.

Petitioners timely filed a petition for redetermination.

                                      OPINION

I.    Burden of Proof

      The Commissioner’s determinations in a notice of deficiency are generally

presumed correct, and the taxpayer bears the burden of proving those

determinations erroneous. 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). Taxpayers must comply with specific requirements for any

deductions claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

      If the taxpayer produces credible evidence with respect to any factual issue

relevant to ascertaining his Federal income tax liability, the burden of proof may

shift from the taxpayer to the Commissioner as to that factual issue. Sec.

7491(a)(1). The shifting of the burden of proof, however, is conditioned upon the

taxpayer’s first demonstrating that he meets the requirements of section

7491(a)(2), including: (1) substantiating any item as required by the Code;
                                           -7-

[*7] (2) maintaining all records required by the Code; and (3) cooperating with the

Commissioner’s reasonable requests for witnesses, information, documents,

meetings, and interviews. See sec. 6001; sec. 1.6001-1(a), (e), Income Tax Regs.

The evidence does not establish that the burden of proof shifts to respondent under

section 7491(a) as to any issue of fact.

II.   Section 469 Losses From Rental Real Estate Activities

      Taxpayers are allowed deductions for certain business and investment

expenses under sections 162 and 212. Generally, an individual is not entitled to a

deduction for a passive activity loss for the year in which that loss is sustained.

See sec. 469(a). Except as provided in section 469(c)(7), the term “passive

activity” includes any rental activity regardless of whether the taxpayer materially

participates. Sec. 469(c)(2), (4).

      Section 469(c)(7) provides that rental activities of certain taxpayers in real

property trades or businesses (sometimes referred to as real estate professionals)

are not per se passive activities under section 469(c)(2) but are treated as a trade or

business subject to the material participation requirements of section 469(c)(1)(B)

if the taxpayer: (1) performs more than one-half of the personal services during

the year in real property trades or businesses in which the taxpayer materially

participates and (2) performs more than 750 hours of services during the taxable
                                            -8-

[*8] year in real property trades or businesses in which the taxpayer materially

participates. Sec. 469(c)(7)(B); see sec. 1.469-9(e)(1), Income Tax Regs. In the

case of a joint return, either spouse must separately satisfy both requirements.

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

       A taxpayer can establish material participation by satisfying any one of the

seven tests provided in the regulations. Sec. 1.469-5T(a), Temporary Income Tax

Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1988); see id. para. (f)(4), 53 Fed. Reg.

5727 (detailing the methods of proof an individual can use to establish

participation in an activity). Each interest in rental real estate is treated as a

separate rental real estate activity unless the taxpayer makes an election by filing a

statement with the taxpayer’s original tax return for the taxable year to treat all

such interests as a single rental real estate activity. Sec. 1.469-9(e)(1), (g)(1), (3),

Income Tax Regs.

       Petitioners did not file a statement with their 2008 or 2009 tax return

electing to treat all of their interests in rental real estate as a single rental real

estate activity. Accordingly, each rental property will be treated as a separate

rental real estate activity, and whether petitioners “materially participated” will be

determined separately for each property. Petitioners have not provided any

testimony or other credible evidence establishing either their claimed time
                                          -9-

[*9] attributable to their rental real estate activities or Mr. McNally’s time

attributable to real property trades or businesses.3

       Neither petitioner qualifies as a real estate professional because neither

performed more than 750 hours during the taxable years at issue in real property

trades or businesses in which he or she materially participated.4 Accordingly, we

find no credible evidence to overturn respondent’s determination that petitioners’

rental real estate activities are passive. Petitioners are therefore not entitled to

offset losses arising from those activities against their other income.

III.   Claimed Deductions

       Section 162(a) allows as a deduction “all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or

business”. A taxpayer may not deduct personal, living, or family expenses unless

the Code expressly provides otherwise. Sec. 262(a).




       3
        As noted in our Findings of Fact, irrespective of the credibility of
petitioners’ journal, the journal itself does not provide proper substantiation of
either petitioners’ rental real estate activities or Mr. McNally’s involvement in real
property trades or businesses.
       4
       Nor do we find that either petitioner performed more than one-half of the
personal services during the taxable years at issue in real property trades or
businesses in which he or she materially participated.
                                        - 10 -

[*10] Certain expenses specified in section 274 are subject to strict substantiation

rules. Sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed. Reg. 46014 (Nov.

6, 1985). No deductions are allowed for, among other things, traveling expenses

(including meals and lodging away from home) and expenses with respect to

“listed property” defined in section 280F(d)(4) “unless the taxpayer substantiates

by adequate records or by sufficient evidence corroborating the taxpayer’s own

statement”: (1) the amount of the expense, (2) the time and place of the travel or

use, and (3) the business purposes of the expense. Sec. 274(d) (flush language);

see sec. 280F(d)(4)(A)(i) and (ii) (defining “listed property” to include passenger

automobiles and other property used for transportation). To substantiate by

adequate records, the taxpayer must provide (1) an account book, a log, or a

similar record and (2) documentary evidence that together are sufficient to

establish each element of an expenditure. Sec. 1.274-5T(c)(2)(i), Temporary

Income Tax Regs., 50 Fed. Reg. 46017 (Nov. 6, 1985). Documentary evidence

includes receipts, paid bills, or similar evidence. Sec. 1.274-5(c)(2)(iii), Income

Tax Regs.
                                        - 11 -

[*11] A.     Charitable Contribution Deductions, Job Expense Deductions,
             and Certain Miscellaneous Deductions

      Petitioners did not introduce credible evidence to properly substantiate their

reported charitable contributions for the taxable years at issue, including their

2009 donation of the 1987 Toyota Camry. Petitioners did not list the fair market

value of the donation, as instructed on Form 8283 if the amount of the deduction

claimed is in excess of $500. Similarly petitioners did not provide any testimony

or other credible evidence regarding their job expenses and certain miscellaneous

deductions in excess of $92 and $91 for 2008 and 2009, respectively.

Accordingly, petitioners have not demonstrated that they are entitled to deductions

for charitable contributions or job expenses and certain miscellaneous deductions

in excess of what respondent has allowed.

      B.     Travel Expenses and Car and Truck Expenses

      We find that petitioners did not meet the heightened substantiation

requirements, noted supra p. 10, with respect to their travel expenses or car and

truck expenses. See sec. 274(d)(1). Irrespective of the credibility of petitioners’

journal, the journal does not establish the amounts of petitioners’ car and truck

expenses or travel expenses, the location of their travel, nor the business purpose

of their expenses. Petitioners failed to provide any testimony at trial relating to
                                       - 12 -

[*12] those expenses. Petitioners have not demonstrated that they are entitled to

deductions for car and truck expenses or travel expenses in excess of what

respondent has allowed.

IV.   Section 6662(a) Penalties

      The Commissioner bears the burden of production with respect to any

accuracy-related penalties under section 6662. See sec. 7491(c); Higbee v.

Commissioner, 116 T.C. 438, 446 (2001). Once the burden of production is met, a

taxpayer bears the burden of proof, including the burden of proving reasonable

cause for the underpayment of Federal income tax. See Rule 142(a); Higbee v.

Commissioner, 116 T.C. at 446-447.

      Section 6662(a) and (b)(2) imposes an accuracy-related penalty on any

portion of an underpayment of Federal income tax that is attributable to the

taxpayer’s “substantial understatement of income tax”.

      An understatement of Federal income tax is substantial if the amount of the

understatement for the taxable year exceeds the greater of 10% of the tax required

to be shown on the return or $5,000. Sec. 6662(d)(1)(A). If the Rule 155

computations confirm substantial understatements for the taxable years at issue,

then respondent has met his burden of producing evidence that the penalties are

justified. See sec. 7491(c).
                                         - 13 -

[*13] Petitioners did not address the section 6662(a) penalties at trial, nor have

they presented any evidence showing reasonable cause for any portions of the

underpayments. See sec. 6664(c)(1). We therefore hold that if Rule 155

computations confirm substantial understatements of income tax, Mr. McNally is

liable for the penalties for underpayments attributable to substantial

understatements of income tax under section 6662(a) and (b)(2).

         We have considered all the other arguments made by the parties, and to the

extent not discussed above, find those arguments to be irrelevant, moot, or without

merit.

         To reflect the foregoing,

                                                  Decision will be entered

                                        under Rule 155.
