In Warren v. Commissioner of Internal Revenue Service, T.C. Summary 2024-20, the Tax Court held that a taxpayer who purchased and renovated a single family home to open an assisted living facility (i.e., group home) while also employed full-time by Lockheed Martin as an engineer, was not entitled to deduct rental real estate losses because he did not qualify as a real estate professional under Code Section 469(2)(2). The court found that the taxpayer did not qualify under Code Section 469(c)(7)(B) because he worked fewer hours at the group home than he did at Lockheed. The court also found that the taxpayer did not qualify for the deduction of up to $25,000 of passive activity losses under Code Section 469(i) because his adjusted gross income exceeded $150,000.
Background
Mr. Warren organized Warren Assisted Living, LLC, in 2015 to open an assisted living facility to provide professional caregiver services. Mr. Warren purchased a single-family home (group home) in 2016 near his residence in Gilbert, Arizona. Mr. Warren began repairing the group home shortly after purchase and later decided to completely revise the layout to add more bedrooms and bathrooms to the existing footprint. During 2017, the year in issue, Mr. Warren was employed by Lockheed Martin Corp. where he worked 1,913 hours as an engineer. As the work continued at the group home, Mr. Warren attended caregiver and business management courses. He also rented habitable rooms at the group home and received $6,000 of rental income. Mr. Warren provided no testimony or other evidence that the tenants received caregiver services or assisted in the renovations while residing at the group home.
On a timely filed 2017 Form 1040, Mr. Warren reported an adjusted gross income (AGI) of $199,974 consisting of wages of $86,305; pension and annuity income of $155,402; no rents received on his Schedule E, and a net loss for rental real estate expenses incurred of $41,733. The Commissioner determined that Mr. Warren was not entitled to the loss deduction claimed, failed to report the rental income received, and was not eligible for the active participation exception provided in section 469(i). The Commissioner issued Mr. Warren the Notice proposing a deficiency of $15,392 and a section 6662(a) accuracy-related penalty of $3,078. The penalty received timely managerial approval. On July 19, 2021, Mr. Warren, while residing in Arizona, timely petitioned this Court disputing the Notice.
Mr. Warren did not keep contemporaneous logs of his time spent renovating the group home. In preparation for trial, Mr. Warren created and presented two-time logs. The first log maintained that Mr. Warren worked 1,421 hours at the group home. It was created one week before the trial. The second log maintained that Mr. Warren worked 1,628 hours at the group home. It was created the night before the trial. Mr. Warren testified that the second log contained corrected information derived from emails and other records he maintained. Some of the hours listed on Mr. Warren’s logs are supported by reference to emails, work permits, and invoices, but most remained unsupported beyond Mr. Warren’s testimony.
Discussion
Internal Revenue Code section 469 generally disallows any passive activity losses for the taxable year. A passive activity is any trade or business in which the taxpayer does not materially participate. Sec. 469(c)(1). Rental activity is treated as passive regardless of whether the taxpayer materially participates. Sec. 469(c)(2). The term “rental activity” means any activity where payments are principally for the use of tangible property. Sec. 469(j)(8).
There are exceptions to the general rule for rental activities for (1) certain taxpayers (real estate professionals) in real property trades or businesses under section 469(c)(7) or (2) passive activity losses up to $25,000 under section 469(i). A taxpayer qualifies as a real estate professional in a given tax year and is not engaged in a 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. Sec. 469(c)(7)(B).
The Commissioner’s determinations in a Notice of Deficiency are generally presumed correct, and the taxpayer bears the burden of proving that he is entitled to any deduction claimed. A taxpayer must maintain sufficient records to substantiate the deduction claimed. The taxpayer may substantiate that he met the section 469(c)(7) hour requirement by any reasonable means. While contemporaneous records are not required, we have routinely held that a post event “ballpark guesstimate” is not sufficient.
Mr. Warren does not qualify as a real estate professional under section 469(c)(7)(B) because he worked fewer hours at the group home than he did at Lockheed. Mr. Warren’s employee status at Lockheed was personal service in a trade or business. Mr. Warren worked 1,913 hours at Lockheed, and his job duties did not involve real property activities. To meet the first requirement of the section 469(c)(7)(B) test, Mr. Warren needed to spend more than 1,900 hours working at the group home. Even if we accepted Mr. Warren’s second log as accurate, the total time spent on the group home totaled only 1,628 hours. Thus, Mr. Warren does not satisfy the section 469(c)(7)(B) test to qualify as a real estate professional.
Section 469(i) allows a taxpayer who “actively participated” in rental real estate activities during any taxable year to deduct up to $25,000 of the passive activity losses attributable to those activities in that year. Sec. 469(i)(1) and (2). This deduction begins to phase out when a taxpayer’s AGI exceeds $100,000 and phases out entirely when AGI reaches $150,000. Mr. Warren is ineligible for the exception under section 469(i) because his AGI exceeded $150,000. We sustain the Commissioner’s determination that Mr. Warren is not entitled to deduct any loss on Schedule E of his 2017 return.
Lastly, the Commissioner determined that Mr. Warren is liable for section 6662(a) accuracy-related penalty. Section 6662 imposes a 20% penalty on any portion of an underpayment of tax required to be shown on a return attributable to any substantial understatement of income tax. Sec. 6662(a), (b)(2). An understatement is substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A). Mr. Warren’s underpayment exceeds both amounts. The Commissioner obtained timely approval to impose the penalty, see Sec. 6751(b)(1), and Mr. Warren did not present any evidence that his underpayment was due to reasonable cause. We, therefore, determine that Mr. Warren is liable for the section 6662(a) accuracy-related penalty.
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