The recent Tax Court decision in Mirch v. Commissioner, T.C. Memo. 2025-128, offers a stark reminder to tax professionals regarding the rigorous substantiation standards required for Real Estate Professional Status (REPS) and material participation, as well as the nuances of collection due process (CDP) procedural defenses. The case involves petitioners who were both attorneys, one of whom possessed an LL.M. in taxation and was a Certified Public Accountant. Despite this professional background, the Court upheld the sustaining of a Notice of Federal Tax Lien (NFTL) and rejected the petitioners’ underlying tax positions due to insufficient evidence and aggressive interpretations of passive activity loss rules.

Case Overview and Procedural History

The petitioners, a married couple practicing law as a partnership in Reno, Nevada, initiated a CDP case to contest an NFTL filing regarding unpaid tax liabilities for 2004, 2006, and 2008. After concessions, the primary year at issue was 2006, though the Court’s analysis required reviewing determinations for 2005 and 2007 to calculate available Net Operating Loss (NOL) carrybacks.

The procedural history is notable for the petitioners’ challenge to the validity of the assessment. The IRS mailed the Notice of Deficiency in June 2010 to the petitioners’ last known address, but the notices were returned unclaimed. The IRS subsequently assessed the tax in December 2010. When the petitioners filed their 2010 return in June 2011, they erroneously listed their street address as "3729" rather than the correct "3728". Consequently, the IRS issued the NFTL notice to the incorrect "3729" address, which became the last known address of record.

Taxpayer Requests for Relief

In the CDP hearing and subsequent Tax Court trial, the petitioners challenged the underlying tax liability for 2006 on several grounds. Because they had not received the Notice of Deficiency, the Court reviewed the underlying liability de novo.

The petitioners sought the following relief:

Deduction of Law Firm Expenses: Allowance of disallowed business deductions and a reduction of reported gross receipts.
Nonpassive Treatment of Rental Losses: Characterization of the wife as a real estate professional or, alternatively, treatment of a short-term rental as a nonpassive activity, allowing losses to offset ordinary income.
NOL Deduction: Application of a 2007 NOL carryback to the 2006 tax year.
Procedural Invalidity: A determination that the assessment was invalid due to irregularities in IRS transcripts and Form 4340, specifically regarding the coding of the assessment as "agreed".

Law Firm Gross Receipts and Substantiation

The petitioners argued that they overstated their law firm gross receipts by erroneously including nontaxable transfers of capital. Gross receipts reported on a return constitute an admission that the taxpayer must overcome by "cogent proof". The Court found the petitioners failed to meet this burden, noting that while they produced QuickBooks records and bank statements, they provided no evidence demonstrating how the reported receipts were calculated or that the alleged nontaxable transfers were actually included in the reported figure.

Regarding deductions, the Court reiterated that deductions are a matter of legislative grace requiring taxpayers to maintain sufficient records under I.R.C. § 6001. The Court declined to apply the Cohan rule to estimate expenses because the petitioners provided insufficient evidence to form a rational basis for an estimate, and certain expenses, such as travel, failed the strict substantiation requirements of I.R.C. § 274(d).

Real Estate Professional Status and Material Participation

A central technical issue was the characterization of losses from two rental properties: a student rental in Rhode Island (Hope Street) and a short-term vacation rental in Reno. The petitioners contended the wife was a real estate professional under I.R.C. § 469(c)(7), thereby exempting the rental activities from per se passive treatment.

To qualify as a real estate professional, a taxpayer must satisfy two tests: performing more than 50% of personal services in real property trades or businesses, and performing more than 750 hours of services in such trades or businesses. Furthermore, the taxpayer must materially participate in each specific rental activity unless an election to aggregate is made under Reg. § 1.469-9(g)(3). The Court noted the petitioners failed to make a formal aggregation election; simply reporting multiple activities on Schedule E is insufficient to effectuate this election.

The Court’s analysis of the activity logs highlights the pitfalls of non-contemporaneous timekeeping. The petitioners submitted an undated log estimating the wife’s hours using standardized blocks of time:

Emails: 12 minutes to read and 12 minutes to send every email, totaling 7.4 hours.
Cleaning: 7 hours per turnover regardless of the length of stay (ranging from 1 to 14 days), totaling 168 hours.
Site Management: 8 hours per day the property was rented, defined as being "on call," totaling 744.5 hours.

The Court rejected this log as a "ballpark guesstimate" under Moss v. Commissioner. The Court found the 7-hour cleaning claim not credible, noting the petitioners also deducted professional cleaning fees. Crucially, the Court held that "on call" time does not count toward material participation; only actual time spent on the activity is countable. Consequently, the wife failed to meet the 750-hour requirement.

Short-Term Rental Exception and Passive Loss Limitations

Alternatively, the petitioners argued the Reno property was nonpassive because it qualified as a short-term rental (average period of customer use less than 7 days) under Temp. Treas. Reg. § 1.469-1T(e)(3)(ii)(A). While the Court agreed the property met the definition of a short-term rental, this classification merely excludes the activity from being per se passive as a "rental activity"; the taxpayer must still establish material participation under one of the seven tests in Temp. Treas. Reg. § 1.469-5T(a).

Because the Court discredited the activity log—specifically the inflated cleaning and "on call" hours—the petitioners failed to establish even 100 hours of participation, precluding satisfaction of the specific material participation test allowing for more than 100 hours of participation where no other individual participates more. Thus, the losses were deemed passive.

Impact on Net Operating Losses

The classification of the rental losses as passive directly impacted the claimed NOL deduction. The petitioners attempted to carry back a 2007 NOL to 2006. However, under I.R.C. § 172(b)(2), an NOL must be carried back to the earliest allowable year first—in this case, 2005.

The Court determined that the petitioners’ 2005 and 2007 rental losses were passive (due to the same failure to prove material participation). This recharacterization increased the petitioners’ taxable income for 2005. Consequently, the valid portion of the 2007 NOL was fully absorbed by the adjusted 2005 taxable income, leaving no remaining NOL to carry forward to the 2006 tax year.

Procedural Analysis: Assessment Validity and Last Known Address

The petitioners raised technical challenges regarding the validity of the assessment and the NFTL. They argued the assessment was invalid because Form 4340 and the account transcript contained Transaction Code 300 and Disposal Code 03, which generally indicate an "agreed" audit deficiency, despite the fact that the assessment arose from a defaulted Notice of Deficiency.

The Court rejected this argument, citing Call v. Commissioner. It held that even if the transcript codes were technically mislabeled, such errors are harmless and do not invalidate an assessment unless the taxpayer can demonstrate prejudice. The Form 4340 satisfied the requirements of Reg. § 301.6203-1 by providing the taxpayer’s name, date of assessment, liability character, period, and amount.

Regarding the mailing of notices, the Court applied I.R.C. § 6303(a). Although the petitioners lived at 3728 Jennings Street, they had erroneously used "3729" on their 2010 tax return, which was the last return filed prior to the NFTL issuance. The IRS’s use of the "3729" address was legally sufficient as it was the taxpayer’s "last known address" of record.

Conclusion

The Tax Court sustained the NFTL filing and upheld the deficiencies. The decision serves as a critical precedent for tax professionals on three fronts:

Recordkeeping: "Ballpark guesstimates" and standardized time blocks for real estate activities will be rejected. "On call" time generally does not count toward material participation.
Procedural Precision: Transcript coding errors regarding "agreed" vs. "defaulted" assessments are generally insufficient to invalidate a liability.
Address Updates: A taxpayer’s typographical error on a tax return establishes the last known address for IRS notice purposes, validating subsequent collection notices sent to that erroneous address.

Prepared with assistance from NotebookLM.