MEMORANDUM FINDINGS OF FACT AND OPINION
Issachar and Rachel Ohana moved from Israel to Northern California in 2003. Soon after, they bought two houses and from 2007 through 2009 poured money into them. They claim deductions for the cost of these improvements, and argue that they were in the trade or business of real-estate development, without ever having bought or sold any real estate during the years before us. They did own the two properties, and they certainly improved them, and for part of that time even rented them out. But did their activities amount to a trade or business? If so, what were their deductible expenses? Or is the Commissioner correct that their activity was only home improvement?
FINDINGS OF FACT
But it was CEVA that was the focus of Ohana's attention. After he'd worked there for ten years, the company was sufficiently impressed that it offered him a senior-executive position anywhere in the world—and Ohana chose the United States. Two years later he became executive vice president of CEVA Global. His new position required constant travel and long and irregular hours. Those hours are irregular because part of his job is to attend meetings all over the world—often in exotic places like Hawaii or Morocco—for weeks at a time. Sometimes Ohana even had a chance to work out of Israel, which gave him an opportunity to visit family. His compensation, however, depended not on the number of hours worked, but on whether his team met certain quotas. And quotas they met: Ohana earned nearly $350,000 in both 2007 and 2008, and more than $550,000 even during the worst of the recession in 2009.
Ohana argues that despite his work for CEVA he was also able to find the time to run a real-estate business. Exactly how much time he spent on his real-estate activity between 2007 and 2009 is fuzzy though, since the only records Ohana kept were reconstructed logs that he pieced together from his Gmail account years later. At trial he referred to it as a "puzzle to put together." He said that he planned to make money by flipping houses—i.e., buying a house with the intent to fix it up and then sell it at a profit. Successfully flipping houses depends on several steps' being executed gracefully, from choosing where to buy (ideally in a neighborhood that attracts deep-pocketed customers) to choosing the right people to do the renovations to keeping transaction costs low. But if something goes wrong, such as trying to flip after a market crash, the flip can flop and the flipper can be stuck with a piece of real estate. Ohana, however, claimed he had an "exit strategy:" He would move into the house and live there until the market was more favorable and then he'd try again to sell the property.
The Ohanas bought their first home in 2005 in Saratoga, California, a town on the edge of Silicon Valley. They bought the Saratoga home in their own names and personally held title to it. In 2006 Ohana sold one of his properties in Israel to fund his next acquisition, a house on Cowper Street in Palo Alto. Gregg Ann Herrern, a real estate agent, brokered the deal. Ohana intended from the get-go to tear down the Cowper Street home and build a new one, but at first he made only enough repairs to make the property livable. He quickly rented it out and left Herrern to manage the property, arrange for any necessary maintenance, and collect rent each month. Later on, when Ohana tried to evict his Cowper Street tenants, he emailed Herrern: "I told them from day one that I am going to build my house on this property."
At the beginning of 2008, however, the Ohanas were still living in their Saratoga home, which they began to remodel. During that year, Ohana also began trying to get a construction loan to refinance his mortgages and fund the building of a new house and cottage on the Cowper Street property. On this loan application Ohana again stated that he would use the money to build a primary residence, rather than invest in a business. And that's just what he got—the loan papers show that he received a residential, not an investment, mortgage. Ohana had by this time formed two limited-liability companies, Ohana Consulting LLC and Zoop LLC, but these neither held title to the two properties nor were the named borrowers for the mortgage and construction loans. Indeed, throughout the three years before us, the Ohanas were the sole title holders and borrowers for both properties, even though the Ohanas reported on their tax returns that Ohana Consulting and Zoop owned both homes and incurred hundreds of thousands of dollars in expenses.
By the end of 2008 Ohana's general contractor had razed the home on the Cowper Street property and begun construction. There are a number of facts that strongly suggest Ohana intended the Cowper Street property to be his family's personal residence, starting with his decision to enroll his daughters in the Palo Alto school system for the 2008 and 2009 school years, before construction had even begun. And as soon as construction was completed (sometime in September 2009), the Ohanas moved in and began renting out the Saratoga home. The new Cowper Street home also had several quirks, such as a custom-built door with a peephole low enough that the five-foot-four Ohana could reach it. And Ohana obsessed over every detail of the project—he was very particular about materials, design, the interior decoration, and even which workers his contractor could use. He visited the property every day he was in Northern California and even had cameras installed so he could monitor the progress from afar. David Avny, his fellow Israeli friend and a CEVA co-worker, described Ohana as involved in everything, "not only in real estate. It's everything about him. He's very methodical."
Ohana's real-estate activity was not entirely limited to the two properties that he owned. In his free time he and Avny went around looking at multi-million-dollar properties in the area. He was on an email listserv that alerted him daily about properties in the area. And he spent a fair amount of time talking with Avny about potential acquisitions. But during the years we're looking at, this was the extent of his real-estate activity with Avny—just scoping out the market and strategizing late into the night about their possible future plans. Ohana nevertheless considered Avny a "partner" in his real-estate endeavors, even though they never went in together on a development project, and not once did they even buy a property through a partnership. Their relationship, we therefore find, was more of a friendship between two men who both dabbled in real estate, and not a partnership. And, of course, Ohana not only didn't sell or offer to sell either of the two properties that he did own, but he actually used both (albeit at different times) as his personal residences.
Ohana's scrupulous attention to detail in building his homes and working for CEVA did not carry over into his tax preparation. He says that he didn't read or even look at his 2007, 2008, or 2009 individual or partnership tax returns before signing and submitting them to the IRS. He didn't compare his Quickbooks accounting records to his tax return. And he didn't provide receipts to the revenue agent during the examination to substantiate the business expenses claimed by Ohana Consulting and Zoop. Instead of checking his returns, Ohana relied on the tax-preparation skills of URS—an organization that specialized in pitching services to Israeli immigrants.
Ohana's experience with URS was apparently typical—although a first-time taxpayer who used URS's services would undergo a two-to-three hour interview and hand over all his income and deduction information, later interaction was minimal. It is unclear from the record whether URS generally acted as a preparer that relied on its clients to characterize items of expense and income, or as a professional that advised its clients of the correct characterization of those items. But we do find that Ohana's dialogue with URS was limited, and that after his first conversation he went straight to a receptionist who already had his returns prepared. All a taxpayer like Ohana had to do then was cut a check and send the return to the IRS.
The Ohanas claimed deductions for nonrental business expenses and rental real-estate activity losses during 2007, 2008, and 2009 in the following amounts:
The Commissioner issued notices of deficiency to the Ohanas for the 2007-2009 tax years in 2011. In them, the Commissioner determined that the Ohanas' rental real-estate losses were passive and also disallowed all of the Ohanas' claimed nonrental real-estate expenses. The notices disallowed the expenses of Ohana Consulting and Zoop, and asserted penalties, too. The Ohanas timely filed petitions to the Tax Court.
We tried the cases in California where the Ohanas live now, as they did when the cases began.
Deductibility of Expenses for Rental and Nonrental Activity
Taxpayers are generally allowed to deduct business and investment expenses under sections 162 and 212,
The deductibility of Ohana's nonrental expenses turns on whether they were personal or incurred in connection with a trade or business.
But did his activity amount to being in a trade or business?
The definition of "trade or business" is not found in the Code, but the Supreme Court has provided us with the a well-known rule of thumb: to be engaged in a trade or business, a taxpayer must (1) be involved in the activity with continuity and regularity (2) the primary purpose of which is income or profit.
Continuity and Regularity
Many witnesses credibly testified that Ohana was heavily involved in his real-estate projects.
There is a second test that taxpayers must pass to show they were engaged in a trade or business, and that is proof that their primary purpose in engaging in the activity was for profit. The case here is affected by the fact that Ohana's activities revolved around properties that either were or became his homes, and we need to figure out whether Ohana's expenses in improving these personal residences were in the pursuit of profit.
The Saratoga Home
We use five factors to determine whether an individual has converted his personal residence into property held for the production of income:
The Ninth Circuit disagreed with our analysis and reasoned that renting a house at its fair market value showed that a taxpayer has a profit motive.
Because Ohana meets neither of the two requirements for characterizing his activities concerning his Saratoga home as a trade or business, we agree with the Commissioner that the Ohanas can deduct no expenses other than mortgage interest and property taxes with respect to that property.
The Cowper Street Property
Ohana argues that the expenses which he incurred in building the new Cowper Street home and cottage were not personal because he intended to make a profit on their eventual sale. But as we said in
We therefore find that the Ohanas were not engaged in the trade or business of real-estate development from 2007 to 2009.
This finding has consequences for the rest of the Ohanas' case. We cannot allow a great many of their contested deductions because they are not connected to a trade or business. But there are other problems with them, to which we now turn. The Ohanas claimed deductible nonrental expenses on the tax returns they filed for Ohana Consulting and Zoop—the partnerships
The only documents in evidence substantiating most of these expenses are Ohana's Quickbooks Profit and Loss Detail charts. But these are just summaries of his assertions, and a taxpayer's uncorroborated statements are generally not enough to support deductions for unsubstantiated amounts claimed.
Some of these expenses are deductible, albeit as personal expenses that the Code allows individuals to deduct, including their mortgage-interest expenses, state-income tax payments, and gifts to charity.
These are allowed.
We're left with what to do about the expenses incurred to renovate both the Saratoga and Cowper Properties. The Ohanas claimed the following deductions for these expenses on their partnership tax returns:
Expenses related to real-estate activities are subject to the Code's capitalization rules. Section 263(a) prohibits a deduction for amounts paid for new buildings, permanent improvements, or betterments made to increase the value of any property or estate. The regulations add that nondeductible expenditures include amounts paid or incurred to add to the value or substantially prolong the useful life of property owned by the taxpayer, or to adapt the property to a new or different use. These rules apply to the new Cowper Street home because we find that Ohana built it for use as a personal residence.
Under section 1.263(a)-1(b), Income Tax Regs., these cost-capitalization rules also apply with respect to the production of real property for use in an activity conducted for profit, and require taxpayers to capitalize the direct and indirect costs of producing such real property. Sec. 263A(a)(1)(B); sec. 1.263A-1(e)(1) and (2), Income Tax Regs. Section 263A(g) defines "producing" as constructing, building, installing, manufacturing, developing, or improving. Sec. 1.263A-2(a)(1)(i), Income Tax Regs. Likewise, section 263A requires the Ohanas to capitalize their direct and indirect costs related to building the Cowper Cottage because it was constructed for—and used as—a rental property. These expenses include property taxes, outside services expenses such as the architect's fees, and expenses for licenses, insurance, and utilities directly benefiting or incurred by reason of the Cowper Cottage.
The renovations of the Saratoga property are a hybrid: Renovation expenses are properly capitalized under the rules of section 263(a) for the 2007 and 2008 years (while the Ohanas still lived there), and then under section 263A in 2009 once they moved into the Cowper Street home and held the Saratoga property as a rental.
All that is left are the penalties. A substantial underpayment exists if the understatement of tax exceeds the greater of 10 percent of the amount of tax required to be shown on the return or $5,000.
The understatements for 2007, 2008, and 2009 exceed both 10 percent of the tax required to be shown and $5,000, based on this concession alone. The Commissioner therefore meets his burden of production on the penalty with simple arithmetic.
The only issue left in dispute is whether Ohana has a section 6664 reasonable-cause-and-good-faith defense. Sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. This requires us to look at the relevant facts and circumstances, including the taxpayer's efforts to assess his own proper tax liability, and, whether he had reasonable cause and showed good faith by relying on professional advice.
We must first decide whether Ohana received any advice at all from URS regarding his tax liabilities. Section 1.6664-4(c)(2) of the regulation defines "advice" as a communication that reflects analysis and conclusions of the tax adviser.
Even if we assume he did receive "advice" the caselaw lists three factors we need to look at to decide whether his reliance on it was reasonable.
We have already touched the first factor—URS was a group of mostly untrained individuals whose responsibilities involved rote data entry based on documents provided by their clients. The documents that Ohana gave them— spreadsheets entitled Profit and Loss Details—bear a title that would likely lead a number cruncher to assume Ohana was running a business. Still, we need to carefully focus on the main issue—whether Ohana reasonably knew or should have known that the tax preparer lacked knowledge in the relevant areas of tax law.
Necessary and Accurate Information
The Ohanas, however, must also establish that they provided necessary and accurate information with respect to all items reported on their tax returns, so that the incorrect returns resulted from the adviser's own errors.
There are problems here. Ohana testified that he had provided all of his real-estate emails to his attorney, who was then supposed to turn them over to the IRS, but we have found that he omitted the one least favorable email—the one in which he told his real-estate agent that he bought the Cowper Street property to build a future home for his family. Ohana also testified that he managed all of his rental properties during 2007-09, but we've found that Herrern was the one who took the tenant applications, picked up their rent checks, handled maintenance requests, and mailed final notices of termination when the Ohanas decided to move in. This casts grave doubt about whether Ohana provided necessary and accurate information to URS, a doubt that becomes still graver because the documents that he gave to URS were estimated reconstructions— unsupported by receipts—of what Ohana believed his income and expenses to be. And given the discrepancies between Ohana's Quickbooks logs and his tax returns, we find that Ohana did not furnish necessary and accurate information to URS.
Actual Reliance in Good Faith
The general rule is that a taxpayer can not avoid his duty to file accurate returns by placing the responsibility on an agent.
While reliance on a professional tax preparer may save a taxpayer from accuracy-related penalties, it won't where an intelligent and skilled taxpayer provided inaccurate information to the return preparer and claims improbably not even to have glanced at his returns to make sure they were satisfactorily prepared.