Do You Actually Need To Rent Before Deducting Rental Expenses?

Let’s say that you own a piece of property. You are trying to claim a rental loss from that property on your tax return. What would you say is the most important requisite in order to claim that loss?

Let’s take a look at the Meinhardt case.

Mr. Meinhardt worked full-time as an architect. His wife operated a day care center out of their home.

In 1976 they purchased 140 acres of farmland in rural Minnesota, consisting of tillable and pasture land and an eighty-year old farmhouse in need of substantial renovation. In subsequent years they sometimes farmed the land, but mostly they rented the land to neighbors for cash rent. They were successful in renting the farmland. They were not so successful in renting the farmhouse.

Thirty years go by.

On their tax returns for 2005, 2006 and 2007 they reported rent from the farmland, as well as substantial expenses for repairs to the old farmhouse. The IRS looked at the return and disallowed the repairs.

They wound up in Tax Court.

The Meinhardts had a simple argument: hey, we own a farm. We rent the farm. For the years under audit our expenses exceeded our income, and we therefore incurred farm losses.

The IRS had a different take. They saw the land being rented on a regular and repetitive basis. There wasn’t much for the IRS to challenge there.

The farmhouse was a different matter. The farmhouse never reported rental income.

That is one lousy rental.

Let’s take a breath. This is not necessarily fatal. The Meinhardts rented a farm. It doesn’t means that all parts and parcels of said farm were equally profitable. As long as it was profitable overall, right?

That, by the way, is the tax concept of aggregation when discussing passive activities, such as rentals.

The Meinhardts explained that they tried to rent the farmhouse, but nobody wanted it. They placed ads in newspapers, put up notices in local stores and spread the word that the house was for rent. The best they could get were renters who would barter for their rent, trading repairs in order to live rent-free. You cannot rent something that no one wants to rent. That doesn’t mean it wasn’t legitimately for rent, though.

The Meinhardts had a reasonable argument.

The IRS, on the other hand, felt that the farmhouse should be separated from the farmland. Hey, they tried to rent the house separate from the land. They rented the land but never rented the house. Does that sound like one rental or two rentals to you?

And there you have the tax concept of disaggregation.

Rent is rent, whether it be land or building. How was the IRS going to pull this off?

The Meinhardts helped them by never reporting rental income from the farmhouse. There was barter, but the documentation was sketchy.

Since the house had not been rented, the IRS wanted to know who had used the house over the years. The Meinhardts used it themselves, but only sporadically and usually coinciding with maintaining the property.

Other tenants included:

·        Wife’s brother (lived their seasonally)

·        Their daughter and son-in-law

·        Their son and his family

It turns out that the Meinhardts – or their family – had used the farmhouse for almost all the years.

Are you kidding me?

Did I mention that the 2005 through 2007 years were not representative, as the Meinhardts were racking up a lot of repairs to that old house? It sure would be nice to slide those expenses over to Uncle Sam.

The Tax Court decided that the farmhouse was either the Meinhardts second residence or it was a property not held for rental – you take your pick. The tax consequence is the same.

The Meinhardts, unhappy with this result, appealed to the Eight Circuit. They lost there too.

What are we to learn from this? That the Meinhardts should never have tried to rent the farmhouse separate from the farmland? That they should have automatically thrown in the farmhouse for a dollar when renting the land? That they never should have allowed the family to stay there? That at least they should have charged the family rent? (I personally think that last one is obvious).

I think we are thinking about this too hard.

Methinks that what the court could not stomach was the Meinhardts selling their house in the suburbs and moving into the farmhouse in 2010.

After fixing it up in 2005, 2006 and 2007.

And deducting it on their tax return.

Courts will “back into” a tax analysis to get the desired result. Happens all the time.

The Meinhardts failed to observe a fundamental tenet of tax strategy: never arm the other side.