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The activities of a person who owned two rental properties in Israel, then bought two properties in the U.S., lived in one of the U.S. properties, then rented it out and moved into the other U.S. property, weren’t a trade or business, despite his claimed intention to make money from flipping properties. And, he wasn’t able to avoid the substantial understatement penalty by arguing that he relied on his tax professional’s advice.

Background: Certain expenses are only deductible if they are incurred in carrying on a trade or business. The definition of “trade or business” is not found in the Code, but the Supreme Court has provided that to be engaged in a trade or business, (1) a person must be involved in the activity with continuity and regularity, (2) the primary purpose of which is income or profit.

A 20% penalty applies for any substantial understatement of income tax. But, no penalty may be imposed with respect to any portion of an underpayment upon a showing by the person that there was reasonable cause for, and the person acted in good faith with respect to, such portion.

Facts: Mr. Ohana was an immigrant from Israel. He held a senior executive position with a high-tech company. The position required “constant” travel, much of which was international, and long and irregular hours.

Mr. Ohana also claimed that he ran a real estate business. His first ventures into real estate were two rental properties in Israel that he bought before the years at issue.

In evidence accepted by the Tax Court, he said that he planned to make money by “flipping” houses. He noted that, as part of his plan, if the market for a particular house wasn’t good at the time he wanted to sell it, 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.

Ohana and his wife bought their first home in 2005 in Saratoga, California.

In 2006, Ohana sold one of his properties in Israel to fund his next acquisition, a house on Cowper Street in Palo Alto. 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 had a real estate company manage the property, arrange for any necessary maintenance, and collect rent each month. On the record deed documenting the purchase, Ohana checked a box on the form that he intended to eventually make the Cowper Street home his primary residence.

At the beginning of 2008, however, Ohana was still living in his Saratoga home, which he 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 showed that he received a residential, not an investment, mortgage.

By the end of 2008, Ohana’s general contractor had razed the home on the Cowper Street property and begun construction. There were a number of facts that strongly suggested 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.

In addition, Ohana and his friend Avny often looked at multi-million-dollar properties in the area. Ohana 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 at issue, 2007-2009, that was the extent of his real-estate activity with Avny—just scoping out the market and strategizing about their possible future plans.

Ohana kept records of his real estate income and expenses on Quickbooks but did not keep records of the time that he spent in real estate activities.

He claimed to have had little involvement with the preparation of his 2007-2009 tax returns and didn’t review them before signing them. He left everything else to URS, an organization that specialized in pitching services to Israeli immigrants. The persons at URS who prepared his return were not accountants or lawyers. When he was a first-time user of URS’s services, he underwent a two-to-three hour interview, but later interaction was minimal. Ohana sent URS all the information related to his income and deductions, including his real-estate activities. URS then entered this data into a computer and generated a tax return. Ohana’s dialogue with URS was limited.

IRS sought to disallow amounts on Ohana’s 2007-2009 returns that were dependent on his real estate activities being a trade or business and sought to impose the substantial understatement penalty.

The Tax Court finds that person failed both “trade or business” tests. The Tax Court found that Ohana failed both the “continuity and regularity” test and the “primary purpose” test.

As to the “continuity and regularity” test, the Court said that, while Ohana may have been extremely involved in the remodeling and renovating of his homes, he was not “continuously or regularly” involved in the business of buying and selling real estate, which was the business he claimed to be in. During the years at issue, he did not sell or buy a single property. And there is ample case law holding that persons with significantly more nonrental real-estate activity than Ohana did not show the high frequency required to be considered regular and continuous. And, the Court said, that while it concluded that Ohana intended to eventually sell the Saratoga and Cowper Street homes, the only steps he took during the relevant tax years were in preparation to rent out the Saratoga home and in preparation to move into the Cowper Street home. Simply upgrading his homes with the desire to make a profit on a sale at some time in the future is not sufficient to meet the regular-and-continuous-activity test for a trade or business.

The Court then noted that the primary purpose test in this case was greatly affected by the fact that Ohana’s activities revolved around properties that either were or became his homes and, therefore it had to figure out whether Ohana’s expenses in improving those personal residences were in the pursuit of profit. It listed five factors to determine whether an individual has converted his personal residence into property held for the production of income: the length of time the house was occupied by the individual as his home before placing it on the market for sale; whether the individual permanently abandoned all further personal use of the house; the character of the property; offers to rent; and offers to sell.

In concluding that his expenses with respect to the Saratoga home didn’t meet this test, the Court emphasized the fact that Ohana never tried to sell Saratoga. Ohana may have chosen to do this because of unfavorable market conditions, but case law suggests that someone who argues that he’s in the business of selling homes should show at least an attempt to sell one.

In concluding that his expenses with respect to the Cowper Street home didn’t meet this test, the Court said that the facts showed that Ohana always intended to make the new Cowper Street property home his personal residence. And, it found that Ohana, like many homeowners, worked on home-improvement projects with an eye to their effect on his property’s value—but that doesn’t mean that his activity was engaged in for profit.

Person couldn’t qualify for reasonable cause defense. The Tax Court ruled that Ohana’s reliance on URS didn’t qualify as reasonable cause with respect to the substantial understatement penalty both because it concluded that Ohana hadn’t received “advice” from URS and because, even if Ohana had received advice, his reliance on it wasn’t reasonable.

Reg. § 1.6664-4(c)(2) defines “advice” as a communication that reflects analysis and conclusions of the tax adviser. The Court concluded that Ohana didn’t meet this definition. Ohana met with his tax preparer once during his initial interview with URS, and his later meetings were with a receptionist who already had his returns prepared. Ohana himself testified that URS performed mainly data entry into software that would generate a tax return. And the URS advisers were neither lawyers nor accountants, as was plain from the obvious errors on the tax returns—for example, Ohana’s rental property in Israel was completely omitted from his returns.

The Court then considered whether, had their been advice from URS, Ohana’s reliance on it was reasonable. It looked to the following three factors from Neonatology Assocs., P.A.  First, was the adviser a competent professional who had sufficient expertise to justify reliance? Second, did the person provide necessary and accurate information to the adviser? Third, did the person actually rely in good faith on the adviser’s judgment?

As to the first of these factors, the Tax Court initially concluded that URS were not competent professionals for this purpose. But then it added a separate criteria—whether Ohana reasonably knew or should have known that the tax preparer lacked knowledge in the relevant areas of tax law. Ohana relied on URS’s assurances that the software URS used was very sophisticated and would eliminate any of Ohana’s concerns because URS’s main role would be reduced to mere data entry. The Court said that reliance on tax-preparation software may not constitute reasonable cause for underreporting of income and corresponding underpayment of income tax. However, the Court find that Ohana did pass this test because URS promised him that its CEO, who was a CPA, a competent professional and owner of the tax-preparation company, would review Ohana’s return—factors that the Court found were sufficient to lead Ohana to believe that URS had the requisite knowledge of tax law to prepare his returns.

As to the second factor, the Court looked to Reg. § 1.6664-4(c)(1)(i) which requires a person to disclose all pertinent facts and circumstances that the person knows, or reasonably should know, to be relevant to the tax treatment of an item. The Court said that Ohana failed this test. It noted that documents that he gave to URS were estimated reconstructions—unsupported by receipts—of what Ohana believed his income and expenses to be. And there were discrepancies between Ohana’s Quickbooks logs and his tax returns.

As to the third factor, the Court said that claiming reliance on a tax preparer and choosing to maintain ignorance of the contents of his returns is not reasonable reliance in good faith.

© 2014 Douglas Rutherford, CPA, CGMA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the  Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

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