Carlos v. Comm'r

*276 OPINION

WELLS, Judge: Respondent determined deficiencies in petitioners' Federal income taxes for 1999 and 2000 as follows: ¹

The issue to be decided is whether losses from petitioners' rental activity constitute passive activity losses pursuant to section 469. ²

*45 Background

The parties have submitted the instant case fully stipulated, without trial, pursuant to Rule 122. The parties' stipulations of fact are incorporated herein by reference and are found as facts in the instant case.

*277 Petitioners are husband and wife. At the time of filing their petition, petitioners resided in Apple Valley, California.

During the years in issue, petitioners owned two commercial real estate properties in Apple Valley, California. One property was located at 22040 Bear Valley Road (Bear Valley Road property), and the other was located at 13685/ 13663 John Glenn Road (John Glenn Road property). Collectively, the Bear Valley Road property and the John Glenn Road property are referred to as the rental properties. Petitioners also owned all of the stock of two S corporations ---Bear Valley Fabricators & Steel Supply, Inc. (steel company), and J& T's Branding Company, Inc. (restaurant).

During 1999 and 2000, petitioners leased the Bear Valley Road property to the steel company and leased the John Glenn Road property to the restaurant.

The steel company agreed to pay rent of $ 120,000 per year to petitioners for the Bear Valley Road property. The steel company*46 paid the rent, which, after taxes, depreciation, and bank charges, resulted in net rental income to petitioners for the Bear Valley Road property of $ 102,646 in 1999 and $ 102,045 for 2000.

The restaurant agreed to pay rent of $ 60,000 per year to petitioners for the John Glenn Road property. The restaurant failed to pay its designated rent in 1999 and 2000, which, after mortgage interest, taxes, depreciation, and amortization incurred by petitioners, resulted in a net loss to petitioners for the John Glenn Road property of $ 41,706 in 1999 and $ 40,169 in 2000.

Petitioners grouped the rental properties together to constitute a single "activity". On Schedules E, Supplemental Income and Loss, of their 1999 and 2000 income tax returns, petitioners netted the income from the Bear Valley Road property and the loss from the John Glenn Road property. For 1999, petitioners subtracted the $ 41,706 net loss on the John Glenn road property from the $ 102,646 net income on the Bear Valley Road property, resulting in net rental income of $ 60,940. Similarly, for 2000, petitioners subtracted the $ 40,169 net loss on the John Glenn Road property from the $ 102,045 net income on the Bear Valley*47 Road property, resulting in net rental income of $ 61,876. Petitioners reported the net rental income as not from a passive activity and reported no passive activity loss.

*278 Respondent disallowed petitioners' net losses on the John Glenn Road property under section 469(a) as passive activity losses.

Discussion

Section 469(a) disallows the passive activity loss of an individual taxpayer. ³*48 The Internal Revenue Code defines "passive activity" as an activity involving the conduct of a trade or business in which the taxpayer does not materially participate. ⁴ "Passive activity", however, generally includes any rental activity, regardless of material participation. Sec. 469(c)(2).

Section 469 does not define "activity". See Schwalbach v. Commissioner, 111 T.C. 215, 223 (1998). The Secretary, however, has prescribed regulations pursuant to section 469(l) that specify what constitutes an "activity". Section 1.469-4(c), Income Tax Regs., sets forth rules for grouping tax items together to determine what constitutes a single "activity". That regulation provides: "One or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of*49 gain or loss for purposes of section 469." Sec. 1.469-4(c)(1), Income Tax Regs. Whether activities constitute an "appropriate economic unit" depends on the facts and circumstances. ⁵

*279 Respondent concedes that petitioners' grouping of the Bear Valley Road property and the John Glenn Road property is an appropriate economic unit. The parties, however, dispute the method for computing passive activity loss within the "activity" grouping.

Section 469(d)(1) defines "passive activity loss" as "the amount (if any) by which -- (A) the aggregate*50 losses from all passive activities for the taxable year, exceed (B) the aggregate income from all passive activities for such year." Passive activity loss is computed by first netting items of income and loss within each passive activity and then subtracting aggregate income from all passive activities from aggregate losses. See id.; sec. 1.469-2T, Temporary Income Tax Regs.,53 Fed. Reg. 5686 (Feb. 25, 1988).

In carrying out the provisions of section 469, section 469(l)(2) authorizes the Secretary to promulgate regulations "which provide that certain items of gross income will not be taken into account in determining income or loss from any activity (and the treatment of expenses allocable to such income)". While the general rule of section 469(c)(2) characterizes all rental activity as passive, section 1.469-2(f)(6), Income Tax Regs., requires net rental income received by the taxpayer for use of an item of the taxpayer's property in a business in which the taxpayer materially participates to be treated as income not from a passive activity (sometimes referred to as the self-rental rule or the recharacterization rule), ⁶ and provides:*52

     (f)(6) Property*51 rented to a nonpassive activity. An amount

   of the taxpayer's gross rental activity income for the taxable

   year from an item of property equal to the net rental activity

   income for the year from that item of property is treated as not

   from a passive activity if the property --

        (i) Is rented for use in a trade or business activity

     * * * in which the taxpayer materially participates * *

     *. ⁷

*280 Petitioners concede that they "materially participated" in the conduct of both the steel company and the restaurant during 1999 and 2000, and they do not contend that section 1.469-2(f)(6), Income Tax Regs., is either invalid or inapplicable. Petitioners, however, contend that computation of passive activity loss requires the netting of income and loss from all items of rental property grouped within the section 469 passive activity and that only after such a computation does section 1.469-2(f)(6), Income Tax Regs., apply to recharacterize passive income as nonpassive. Respondent contends that section 1.469-2(f)(6), Income Tax Regs., requires the removal of self-rental income from the passive activity loss computation and that, after income from the Bear Valley Road property is properly removed from the passive activity loss computation, petitioners are left with no passive income to offset against the passive loss on the John Glenn Road property. We conclude that section 469(d) and the legislative regulations*53 of section 1.469-2(f)(6), Income Tax Regs., support respondent's position.

Section 469(l)(2) explicitly authorizes the promulgation of regulations to remove certain items of gross income from the calculation of income or loss from any activity. Section 1.469-2(f)(6), Income Tax Regs., is a legislative regulation and is entitled to appropriate deference from this Court. See Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 81 L. Ed. 2d 694, 104 S. Ct. 2778 (1984). In Chevron, the U.S. Supreme Court stated: "Such legislative regulations are given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statute." Id. at 844. We have previously held that section 1.469-2(f)(6), Income Tax Regs., is not arbitrary, capricious, or manifestly contrary to section 469(l)(2). Krukowski v. Commissioner, 114 T.C. 366 (2000), affd. 279 F.3d 547 (7th Cir. 2002); Shaw v. Commissioner, T.C. Memo. 2002-35; Sidell v. Commissioner, T.C. Memo. 1999-301, affd. 225 F.3d 103 (1st Cir. 2000). The Courts of Appeals for the First, Fifth, and Seventh Circuits have also upheld the validity of section 1.469-2(f)(6)*54 , Income Tax Regs. See Krukowski v. Commissioner, 279 F.3d 547 (7th Cir. 2002); Sidell v. Commissioner, 225 F.3d 103 (1st Cir. 2000); Fransen v. United States, 191 F.3d 599 (5th Cir. 1999).

Section 1.469-2(f)(6), Income Tax Regs., explicitly recharacterizes net rental activity income from an "item of *281 property" rather than net income from the entire rental "activity". Both section 469 and the regulations thereunder clearly distinguish between net income from an "item of property" and net income from the entire "activity", ⁸ which might include rental income from multiple items of property. ⁹ Under the authority of section 469(l)(2), the Secretary could have implemented regulations to remove items of gross income equal to net income from the entire activity, but the Secretary instead implemented regulations to recharacterize net income from a specific item of self-rental property. The use of the term "item of property" leads us to conclude that respondent's interpretation of the regulation is correct. Accordingly, in the instant case, self-rental income from the Bear Valley Road property is removed from the passive activity loss*55 computation, leaving no passive income to be offset by the passive loss on the John Glenn Road property.

*56 Section 469(d)(1) defines passive activity loss as the excess of losses from passive activities over income from passive activities. Consequently, recharacterization of "self-rental income" under section 1.469-2(f)(6), Income Tax Regs., as not from a passive activity effectively removes the income from the passive activity loss computation. Removal of a single item of income from such computation does not affect the passive characterization of items remaining within the activity. See Shaw v. Commissioner, supra."Under the self-rented property rule, the net rental income from self-rented property is treated as nonpassive income and the net rental losses are treated as passive losses, even though the rental activities are passive activities." Id.

Although we have not previously decided whether grouping items of passive income and loss within a single section 469 activity precludes recharacterization under section 1.469-2(f)(6), Income Tax Regs., of income that would otherwise offset *282 the passive loss, ¹⁰*58 we have consistently upheld recharacterization of passive income which would otherwise offset passive loss without considering the effect of the activity grouping. See, *57 e. g., Krukowski v. Commissioner, 114 T.C. 366 (2000); Schwalbach v. Commissioner, 111 T.C. 215, 219-224 (1998); Cal Interiors, Inc. v. Commissioner, T.C. Memo. 2004-99; Shaw v. Commissioner, supra; Sidell v. Commissioner, T.C. Memo. 1999-301; Connor v. Commissioner, T.C. Memo. 1999-185, affd. 218 F.3d 733 (7th Cir. 2000). ¹¹ In each of these cases, we validated application of section 1.469-2(f)(6), Income Tax Regs., to recharacterize specific items of income, leaving remaining items of passive loss with no offset.

In the instant case, we conclude that activity grouping does not preempt the application of section 1.469-2(f)(6), Income Tax Regs. To hold otherwise would undermine the congressional purpose for enacting section 469 and authorizing section 1.469-2(f)(6), Income Tax Regs., to wit: the prevention of sheltering of nonpassive income with passive losses. H. Conf. Rept. 99-841 (Vol. II), at II-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147. The conference*59 report accompanying section 469 describes this legislative purpose:

     Regulatory authority of Treasury in defining non-passive

   income. -- The conferees believe that clarification is desirable

   regarding the regulatory authority provided to the Treasury with

   regard to the definition of income that is treated as portfolio

   income or as otherwise not arising from a passive activity. The

   conferees intend that this authority be exercised to protect the

   underlying purpose of the passive loss provision, i.e.,

   preventing the sheltering of positive income sources through the

   use of tax losses derived from passive business activities.

     Examples where the exercise of such authority may (if the

   Secretary so determines) be appropriate include the following *

   * * (2) related party leases or sub-leases, with respect to

   property used in a business activity, *283 that have the effect of

   reducing active business income and creating passive income

   * * *. [Id.]

The facts of the instant case appear to fall within the description of activity that Congress intended to prevent.

*60 Petitioners' interpretation of section 1.469-2(f)(6), Income Tax Regs., would effectively allow a taxpayer to subvert Congress's intent. Petitioners' interpretation would allow a taxpayer to convert nonpassive income into passive income against which passive losses could be offset by manipulating the payment of rent from a business controlled by the taxpayer on property rented from the taxpayer to the controlled business. ¹²*61 See Shaw v. Commissioner, T.C. Memo. 2002-35. By converting nonpassive income into passive income in this manner, such a taxpayer would be able to shelter otherwise nonpassive income with passive losses. Petitioners' interpretation would allow petitioners to shelter nonpassive income from the Bear Valley Road property with passive loss from the John Glenn Road property, contrary to congressional intent. ¹³

Accordingly, we hold that net rental income from the Bear Valley Road property constitutes income not from a passive activity. Net rental loss from the John Glenn Road property, however, retains its characterization as loss from passive activity. Consequently, the loss is properly disallowed under section 469(a). ¹⁴

*62 *284 To reflect the foregoing,

Decision with respect to the deficiencies will be entered for respondent; decision with respect to the accuracy-related penalties pursuant to section 6662(a) will be entered for petitioners.