Depreciation Deduction, Rental Income, And Passive Activity

Depreciation Deduction, Rental Income, And Passive Activity

Heather P. Dunn and Edison Dunn v. Comm’r |T.C. Memo 2022-112 | November 29, 2022 | Wells, J. | Dkt. No. , No. 9996-17

Short Summary:  At issue in this case are several deductions that the taxpayers claimed – including depreciation and certain losses from passthrough of their wholly-owned corporation.  Unfortunately, the taxpayers in this case failed to maintain sufficient documentation and failed to satisfy multiple rules that would have allowed them to claim such deductions.  As a result, the deductions were denied, and accuracy-related penalties were sustained.

Key Issues:

  • Whether the taxpayers were entitled to a depreciation deduction on the wife’s Ford Explorer;
  • Whether the taxpayers were entitled to a deduction of certain net losses; and
  • Whether the taxpayers were entitled to deduct flowthrough losses from an entity they owned, Magnet Development LLC.
  • Whether the taxpayers were properly assessed accuracy-related penalties.

Facts and Primary Holdings

  • The taxpayers formed Magnet Development, LLC (“Magnet”), in February 2007 to manage investments in real estate.
  • On March 14, 2008, Magnet purchased a 21-unit apartment building in Hephzibah, Georgia (the “Hephzibah Building”).
  • Taxpayers lived approximately 150 miles from the Hephzibah Building. To assist in managing the Hephzibah Building Magnet employed Ebony Calhoun from January 5 to July 27, 2013, to collect rents, show apartments, and clean vacant apartments.
  • In addition Magnet hired Augusta Partners Property Management, LLC (“Augusta Partners”), to rent, lease, operate, and manage the Hephzibah building pursuant to a contract with an effective date of January 2, 2014. Taxpayers owned additional properties in Athens and Snellville, Georgia, in their individual names and which they managed on their own.
  • During the years in issue taxpayer husband was employed as a full-time technology support specialist with Gwinnett County Public Schools, and taxpayer wife was employed as a full-time computer specialist with Huron Consulting Services, LLC. In addition they attempted to work as full-time real estate professionals.
  • In order to substantiate their real estate activities, taxpayers kept two separate logs with respect to the hours they claim to have spent working on the Hephzibah Building, the Athens property, and the Snellville property in 2013 and 2014. One log relates to activity conducted at the Hephzibah Building in 2014. This log provides the date along with a two- or three-word description of the job completed; it does not list the hours spent working. The second log relates to activity conducted at all three properties in 2013 and 2014. This log provides the date, name of the property, hours worked, and a vague description of the work performed; it does not specify the tasks each petitioner individually performed.
  • Taxpayers each owned 50% of Magnet. Magnet timely filed Partnership tax returns for the years in issue. Magnet reported income and claimed expense deductions for the Athens and Snellville properties on its Forms 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation. It also claimed depreciation deductions at 100% business use of a 2013 Ford Explorer that petitioner wife purchased in May 2013. It reported net losses for both years in issue.
  • Taxpayers filed a joint individual income tax return for each year in issue; however, they did not make an election to group their rental real estate activities as one activity for purposes of section 469(c)(7)(A) for either year. They claimed flowthrough losses from Magnet of $85,260 and $48,740 for taxable years 2013 and 2014, respectively. Taxpayers also claimed a loss deduction of $7,028 on their Schedule E, Supplemental Income and Loss, for 2014.
  • On June 8, 2016, the examiner’s group manager signed a Civil Penalty Approval Form with respect to the examination of Magnet approving accuracy-related penalties pursuant to section 6662(a) on the individual shareholders’ returns for 2013 and 2014. On September 19, 2016, the group manager signed a second Civil Penalty Approval Form approving accuracy-related penalties against taxpayers for the same period. On February 1, 2017, the IRS issued taxpayers a notice of deficiency for the years in issue.
  • The Taxpayers failed to substantiate the cost of the Ford Explorer, when it was placed in service, the business percentage use of the vehicle, and the previously allowed depreciation. Therefore, the Tax Court sustained the disallowance of a deduction for depreciation for both 2013 and 2014.
  • Regarding the real estate losses, for 2013 and 2014 Magnet reported income, expenses, and resulting losses of $3,662 and $5,100 for 2013 and 2014, respectively, for the properties in Athens and Snellville. However, the taxpayers owned these properties in their individual capacities, not Magnet. Taxpayers did not provide any evidence to show that Magnet was entitled to deduct these losses. Therefore, the Tax Court denied those deductions as flow-through losses.
  • Because the taxpayers were not able to provide evidence of their adjusted bases in Magnet, they were not entitled to deduct losses from Magnet for 2013 and 2014.
  • Additionally, the taxpayers failed to show that any amounts with respect to their rental real estate activities were at risk, thereby precluding a deduction of losses related to such activities.
  • The taxpayers failed to satisfy tests for qualification as “real estate professionals,” (see, infra), and therefore they did not qualify for the exception to the general rule that a rental activity is per se passive.
  • Regarding the assessment of penalties, in this case both Civil Penalty Approval Forms were signed before the issuance of the notice of deficiency. Therefore, the requirements of section 6751(b) (described, infra) are met.
  • The Tax Court found that the understatements of tax in this case satisfied the threshold requirements and therefore accuracy-related penalties were proper and were sustained. Further, the taxpayers failed to establish reasonable cause for their understatements of tax.

Key Points of Law:

  • Deductions are a matter of legislative grace, and a taxpayer must prove his or her entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). A taxpayer claiming a deduction on a federal income tax return must demonstrate that the deduction is allowable pursuant to a statutory provision and must further substantiate that the expense to which the deduction relates has been paid or incurred. § 6001; Hradesky v. Commissioner, 65 T.C. 87, 89–90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).
  • For property used in a trade or business or held for the production of income, a depreciation deduction is allowed for reasonable exhaustion or wear and tear. § 167(a).
  • To substantiate entitlement to a depreciation deduction, a taxpayer must establish the property’s depreciable basis by showing the cost of the property, its useful life, and the previously allowed depreciation. Cluck v. Commissioner, 105 T.C. 324, 337 (1995). To be entitled to a deduction for an automobile, a taxpayer must establish that the automobile was used at least partially for business, and the deductions will be allowed only to the extent of its business use. In addition, a claimed deduction with respect to any “listed property”—a category including “any passenger automobile”—is subject to the heightened substantiation requirements under section 274(d). See 280F(d)(4) (defining “listed property”).
  • Pursuant to section 704(d) “[a] partner’s distributive share of partnership loss (including capital loss) shall be allowed only to the extent of the adjusted basis of such partner’s interest in the partnership at the end of the partnership year in which such loss occurred.”
  • Pursuant to section 465(a) taxpayers are entitled to losses from rental real estate only to the extent of the aggregate amount with respect to which the taxpayer is at risk for such activity at the close of the year. Amounts considered at risk include (1) the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity and (2) borrowed funds that the taxpayer is personally liable for or has pledged property for the borrowed amount. § 465(b).
  • Taxpayers may deduct costs for certain business and investment expenses under section 162. If the taxpayer is an individual, section 469 generally disallows any passive activity loss deduction for the taxable year and treats it as a deduction or credit for the next taxable year. § 469(a) and (b).
  • A passive activity loss is defined as the excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year. § 469(d)(1).
  • A passive activity is any trade or business in which the taxpayer does not materially participate. § 469(c)(1). A taxpayer is treated as materially participating in an activity only if his or her involvement in the operations of the activity is regular, continuous, and substantial. § 469(h)(1). Rental activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates. 469(c)(2). A taxpayer who actively participates in a rental real estate activity can deduct a maximum loss of up to $25,000 per year (subject to phaseout limitations) related to the activity. § 469(i)(1)–(3).
  • Section 469(c)(7) provides an exception to the general rule that a rental activity is per se passive. The rental activities of a taxpayer in a real property trade or business (a real estate professional) are not subject to the per se rule of section 469(c)(2). § 469(c)(7); see Kosonen v. Commissioner, T.C. Memo. 2000-107, slip op. at 9; Treas. Reg. § 1.469-9(b)(6), (c)(1). Rather, the rental activities of a real estate professional are subject to the material participation requirements of section 469(c)(1). See Reg. § 1.469-9(e)(1).
  • A taxpayer qualifies as a real estate professional if: (1) more than one-half of the personal services performed in trades and businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates and (2) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. § 469(c)(7)(B). Section 469(c)(7)(C) provides that “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.” In the case of a joint return the above requirements are satisfied if either spouse separately satisfied these requirements. § 469(c)(7)(B).
  • A taxpayer is considered to have materially participated in an activity if one of the seven tests listed in the regulations is satisfied. Temp. Treas. Reg. § 1.469-5T(a). A taxpayer may establish hours of participation by any reasonable means. para. (f)(4). Contemporaneous daily reports are not required if the taxpayer can establish participation by other reasonable means. Id. Reasonable means include “appointment books, calendars, or narrative summaries” that identify the services performed and “the approximate number of hours spent performing such services.” Id.
  • The IRS bears the burden of production with respect to the penalty imposed by section 6662(a). § 7491(c). This burden of production includes producing evidence that the IRS has complied with the procedural requirements of section 6751(b). Frost v. Commissioner, 154 T.C. 23, 34 (2020). Once the IRS satisfies this burden, the taxpayer must come forward with contrary evidence. Id.
  • The IRS must show compliance with section 6751(b)(1), which requires that certain penalties be personally approved in writing by the immediate supervisor of the individual making the determination. See Graev v. Commissioner, 149 T.C. 485, 493 (2017), supplementing and overruling in part 147 T.C. 460 (2016).
  • Section 6662(a) and (b)(2) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax required to be reported on a return that is attributable to a substantial understatement of income tax. An understatement of tax is equal to the amount of tax required to be shown on the return, less the amount shown. § 6662(d)(2)(A). With respect to individual taxpayers, an understatement of tax is substantial if it exceeds the greater of 10% of the tax required to be shown in the return or $5,000. § 6662(d)(1)(A).
  • The penalty for an underpayment attributable to a substantial understatement of income tax under section 6662(b)(2) will not apply to the extent that a taxpayer shows he or she both had reasonable cause and acted in good faith with respect to that portion of the underpayment. § 6664(c)(1).

Insight:  This case demonstrates the necessity of adequate documentation to substantiate frequently litigated deduction provisions.  In particular, this case shows the necessity of maintaining proper formalities as it relates to ownership of property and the expenses associated with such property.  Here, the taxpayers attempted to deduct amounts that were properly deductible by their wholly-owned corporation, and vice versa – an error that could have been corrected with accurate bookkeeping.

Have a question? Contact Jason Freeman And Team, Freeman Law.

Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service.
He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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