Cincyblogs.com
Showing posts with label residence. Show all posts
Showing posts with label residence. Show all posts

Monday, August 28, 2023

The Augusta Rule And Renting To Yourself


I came across the Augusta rule recently.

This is Code section 280A(g), the tax provision that allows one to rent their home for less than 15 days per year without paying tax on the income. It got its name from the famous Augusta National Golf Club in Georgia. There would not be sufficient housing during the Masters without participation by local homeowners. The section has been with us since the 1970s.

There are requirements, of course:

(1)  The property must be in the U.S.

(2)  The property needs to be a residence. Mind you, it does not need to be your primary residence. It can be a second home. Or a third home, if you are so fortunate.

(3)  The house cannot be a place of business.

a.    The Augusta rule does not work well with an office-in-home, for example.

(4)  Rental expenses (excluding expenses such as mortgage interest and taxes which are deductible irrespective of any rental) become nondeductible.

(5)  A proprietorship (or disregarded single-member LLC) does not qualify. Mind you, a corporation you wholly own will qualify, but your proprietorship will not.

a.    Another way to say this is that both the rental income and expense cannot show up on the same tax return.

(6)  The rent must be reasonable.

(7)  There must be a business purpose for the rental.

Tax advisors long ago realized that they could leverage the Augusta rule if the homeowner also owned a business. How? Have the business rent the house from the homeowner for less than 15 days over a rolling 12-month period.

Can it work?

Sure.

Will the IRS challenge it?

Let’s look at a recent case to see a common IRS challenge to Augusta-rule rentals.

Two anesthesiologists and an orthopedic representative owned Planet LA, LLC (Planet). Planet in turn owned several Planet Fitness franchises in Louisiana. It opened its first one in 2013 and was up to five by 2017 when it sold all its franchises.

The three shareholders had issues with regular business meetings because of work schedules and distance. Beginning in 2015 they decided to have regular meetings at their residences. Planet would pay rent (of course), which varied in amount until it eventually settled on $3,000 per month to each shareholder.

One of the advantages of having three shareholders was being able to apply the Augusta rule to three houses. If you think about it, this allowed Planet to have up to 42 meetings annually without voiding the day count for any one residence.

Let’s do some quick math.

$3,000 x 3 shareholders x 14 meetings = $126,000

Planet could deduct up to $126,000 and the shareholders would report no rental income.

Sweet.

The IRS wanted to look at this.

Of course.

The first IRS challenge: show us agendas and notes for each meeting.

Here is the Court:

Petitioners failed to produce any credible evidence of what business was conducted at such meetings, and their testimony was vague and unconvincing regarding the meetings.”

Oh, oh.

The second challenge: the revenue agent researched local rental rates for meeting space. He determined that one could rent space accommodating up to 1,200 people for $500 per day.

The shareholders could not prove otherwise.

Here is the Court:

While petitioners argue that the $500 rent determined by … was not reasonable, we disagree and find to the contrary that $500 allowed per month is actually generous.”

This was almost too easy for the IRS.

·      Prove the number of meetings.

·      Multiply that number by $500.

The IRS allowed Planet rent deductions as follows:

          2017           none, as no meetings were proven

          2018           12 meetings times $500 = $6,000

          2019           9 meetings times $500 = $4,500

The shareholders had deducted $290,900 over three years.

The IRS allowed $10,500.

Yep, that is an IRS adjustment of over $280 grand over three years, with minimal effort by the IRS.

And that is how the IRS goes after the Augusta rule in a self-rental context.

The takeaway?

The Augusta rule can work, but you want to document and substantiate everything.

You want to have agendas for every meeting, perhaps followed up with minutes of the same.

Be careful (and reasonable) with the rental rate. This is not VRBO. You are renting a portion of a house, not the full house. You are renting for a portion of a day, not for days or weeks. You cannot just look up weekly house rentals online and divide them by seven. Those rental rates are for a different use and not necessarily comparable to business use of the residence.

You may want to formally invoice the business.

You want to pay the rent from the business bank account.

Our case this time was Sinopoli et al v Commissioner, T.C. Memo 2023-105.

Sunday, December 11, 2022

A House And A Specialized Trust


I saw a QPRT here at Galactic Command recently,

It had been a while. These things are not as common in a low interest rate environment.

A QPRT (pronounced “cue-pert”) is a specialized trust. It holds a primary or secondary residence and – usually – that is it.

Why in the world would someone do this?

 I’ll give you a common example: to own a second home.

Let’s say that you have a second home, perhaps a lake or mountain home. The children and grandchildren congregate there every year (say summer for a lake home or the holidays for a mountain home), and you would like for this routine and its memories to continue after you are gone.

A couple of alternatives come immediately to mind:  

(1)  You can bequeath the property under will when you die.

(2)  You can gift the property now.

Each has it pros and cons.

(1) The property could continue to appreciate. If you have significant other assets, this appreciation could cause or exacerbate potential estate taxes down the road.

(2) You enjoy having and using the property and are not quite ready to part with it. You might be ready years from now - you know: when you are “older.”

A QPRT might work. Here is what happens:

(1) You create an irrevocable trust.

a.    Irrevocable means that you cannot undo the trust. There are no backsies.

(2) You transfer a residence to the trust.

a.    The technique works better if there is no mortgage on the property. For one thing, if there is a mortgage, you must get money into the trust to make the mortgage payment. Hint: it can be a mess.

(3) You reserve the right to use the property for a period of years.

a.    This is where the fancy planning comes in.

b.    It starts off with the acknowledgement that a dollar today is more valuable than a dollar a year (or years) from now. This is the “time value of money.”

c.    At some point in time the property is going to the kids and grandkids, but … not … right …now.     

d.    If the property is worth a million dollars today, the time value of money tells us that the gift (that is, when the property goes to the kids and grandkids) must be less than a million dollars.  

e.    There is a calculation here to figure out the amount of the gift. There are three key variables:

                                               i.     The age of the person making the gift

                                             ii.     The trust term

                                           iii.     An interest rate

A critical requirement of a QPRT is that you must outlive the trust term. The world doesn’t end if you do not (well, it does end for you), but the trust itself goes “poof.” Taxwise, it would be as if you never created a trust at all.

(4) There is a mortality consideration implicit here. The math is not the same for someone aged 50 compared to someone aged 90.

(5) Your retained right of use is the same thing as the trust term. You probably lean toward this period being as long as possible (if a dollar a year from now is worth less than a dollar today, imagine a dollar ten years from now!). That reduces the amount of the gift, which is good, but remember that you must outlive the trust term. There is push-and-pull here, and trust terms of 10 to 15 years are common.

We also need an interest rate to pull this sled. The government fortunately provides this rate.

But let’s go sidebar for a moment.

Let’s say you need to put away enough money today to have $5 a year from now. You put it in a bank CD, so the only help coming is the interest the CD will pay. Let’s say the CD pays 2%. How much do you have to put away today?

·      $5 divided by (100% + 2%) = $4.90

OK.

How much do you have to put away if the CD pays 6%?

·      $5 divided by (100% + 6%) = $4.72

It makes sense if you think about it. If the interest rate increases, then it is doing more of the heavy lifting to get you to $5. Another way to say this is that you need to put less away today, because the higher interest is picking up the slack.

Let’s flip this.

Say the money you are putting in the CD constitutes a gift. How much is your gift in the first example?

$4.90

How much is your gift in the second example?

$4.72

Your gift is less in the second example.

The amount of your gift goes down as interest rates go up.

What have interest rates been doing recently?

Rising, of course.

That makes certain interest-sensitive tax strategies more attractive.

Strategies like a QPRT.

Which explains why I had not seen any for a while.

Let me point out something subtle about this type of trust.

·      What did we say was the amount of the gift in the above examples?

·      Either $4.90 or $4.72, depending.

·      When did the gift occur?

·      When the trust was funded.

·      When do the kids and grandkids take over the property?

·      Years down the road.

·      How can you have a gift now when the property doesn’t transfer until years from now?

·      It’s tax magic.

But what it does is freeze the value of that house for purposes of the gift. The house could double or triple in value before it passes to the kids and grandkids without affecting the amount of your gift. That math was done upfront and will not change.

A couple of more nerd notes:

(6) We are also going to make the QPRT a “grantor” trust. This means that we have introduced language somewhere in the trust document so that the IRS does not consider the QPRT to be a “real” trust, at least for income tax purposes. Since it is not a “real” trust, it does not file a “real” income tax return. If so, how and where do the trust numbers get reported to the IRS? They will be reported on the grantor’s tax return (hence “grantor trust”). In this case, the grantor is the person who created the QPRT.

(7)  What happens after 10 (or 15 or whatever) years? Will the trust just kick you out of the house?

Nah, but you will have to pay fair-market rent when you use the place. It is not worst case.

There are other considerations with QPRTs – like selling the place, qualifying for the home sale exclusion, and forfeiting the step-up upon the grantor’s death. We’ll leave those topics for another day, though.


Sunday, April 21, 2019

Converting A Residence To A Rental


I have a client who owns a very nice house. Too nice, in fact, at least for its neighborhood. My client used to have a contracting business, and he used his business talents and resources to improve his residence. He is now thinking of moving to another city, and it is almost assured he will lose money when he sells his house.

He is quite creative in thinking of ways to make that loss tax deductible.

The first thought is to convert it to a rental. One can deduct losses on the sale of a rental, right?

There are two significant issues with this plan. One has to do with the amount of loss one can deduct when the rental is underwater – that is, when it costs more than it is worth. The second has to do with whether there actually is rental activity.

We have previously talked about the second point, especially when one rents to family. Doing so is not fatal, but doing so on the cheap (not charging rent or enough rent) is.

Consider the following:

The Langstons purchased a residence (75th Place) in 1997.

They lived there until 2005, when they moved to an apartment. They kept some of their possessions at 75th Place until they could move them to storage.

Renovations to 75th Place were completed in 2010.

In 2011 they received an unwanted telephone call from their insurance agent. Someone had to live at 75th Place or the insurance would be terminated.

In July, 2011 Mr. Langston rented the property to a fraternity brother for $500 a month.
COMMENT: The market rent was between $2,500 and $2,800 a month, but the fraternity brother would be home about five days per month. Mr. Langston prorated the rent accordingly.
In 2013 they finally sold 75th Place. They deducted a loss of over $400 grand.
QUESTION: Do you think they successfully converted the property to a rental?
Let’s consider a few factors.

·      What was their intent when they moved to an apartment?

If the intent was to renovate and sell, this would indicate an income-producing purpose. The problem is that the renovations went on forever.

·      They tried to rent the property

No, actually they did not. In fact, the Court thought that they rented the property only after the insurance company threatened to cut-off their insurance.

·      They actually rented the property

For much less than market value rent. The Court was not impressed by that.

·      They tried to sell the property

Eventually, after nearly a decade and after never marketing the property. They did not even seek an appraisal until a refinancing required them to do so.

The Court decided that they never converted the property to a rental. There was no deductible loss.

Zero surprise. I get the feeling that the taxpayers did whatever they wanted for however long, and near the end they wanted some tax leverage from the deal. It was a bit unfair to the tax practitioner, as some planning – any planning – might have helped.

Let’s go crazy with their planning. What can we do….? Let me think, let  me… I got it! How about actually renting the place before the insurance company is about to drop you? How about charging market rent – or at least close?  How about listing the house with a realtor? Shheeesssh.

I suspect my client is shrewder than the Langstons. He however cannot get past the second tax issue.

You see, when you have a personal asset (say your residence) which you convert to income-producing status (say a rental), you have to look at its basis and its fair market value when you convert.

Basis is a fancy word for what you paid to acquire or improve the asset. Say that my client has $1.5 million in his house.

Say he converts May 1st, when the house is worth $1 million.

He now has a “dual basis” situation.

His basis for calculating gain is $1.5 million.

But his basis for calculating loss is $1 million.

You see what happened? He was hoping to use that $1.5 million to calculate any loss on sale. Folks, the IRS figured out this gimmick ages ago. That is how we wound up with the dual basis rule.

I suspect the Langstons had a similar situation, but they never got to first base. You see, their activity had to qualify first as a rental before the Court would have to consider the dual basis rule. The activity didn’t, so the Court didn’t.

Our case this time was Carlos and Pamela Langston, TC Memo 2019-19.

Sunday, July 1, 2018

TurboTax and Penalties


I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000
          The mortgage is             $270,000
          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000
          The house cost               (290,000)
          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000
          The house is worth        (215,000)
          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:
§ 108 Income from discharge of indebtedness.
(a)  Exclusion from gross income.
(1)  In general.
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-
(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-
(i)  before January 1, 2018, or
(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000
          The house cost               (290,000)
          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.
COMMENT: There was enough here to use a tax professional.
They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:
This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”
Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.
… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”
They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.


Thursday, November 19, 2015

The Income Awakens


Despite the chatter of politicians, we are not soon filing income taxes on the back of a postcard. A major reason is the calculation of income itself. There can be reasonable dispute in calculating income, even for ordinary taxpayers and far removed from the rarified realms of the ultra-wealthy or the multinationals.    

How? Easy. Say you have a rental duplex. What depreciation period should you use for the property: 15 years? 25? 35? No depreciation at all? Something else?

And sometimes the reason is because the taxpayer knows just enough tax law to be dangerous.

Let’s talk about a fact pattern you do not see every day. Someone sells a principal residence – you know, a house with its $500,000 tax exclusion. There is a twist: they sell the house on a land contract. They collect on the contract for a few years, and then the buyer defaults. The house comes back.  

How would you calculate their income from a real estate deal gone bad?

You can anticipate it has something to do with that $500,000 exclusion.

Marvin DeBough bought a house on 80 acres of land. He bought it back in the 1960s for $25,000. In 2006 he sold it for $1.4 million. He sold it on a land contract.

COMMENT: A land contract means that the seller is playing bank. The buyer has a mortgage, but the mortgage is to the seller. To secure the mortgage, the seller retains the deed to the property, and the buyer does not receive the deed until the mortgage is paid off. This is in contrast to a regular mortgage, where the buyer receives the deed but the deed is subject to the mortgage. The reason that sellers like land contracts is because it is easier to foreclose in the event of nonpayment.
 


 DeBough had a gain of $657,796.

OBSERVATION: I know: $1.4 million minus $25,000 is not $657,796. Almost all of the difference was a step-up in basis when his wife passed away.  

DeBough excluded $500,000 of gain, as it was his principal residence. That resulted in taxable gain of $157,796. He was to receive $1.4 million. As a percentage, 11.27 cents on every dollar he receives ($157,796 divided by $1,400,000) would be taxable gain.

He received $505,000. Multiply that by 11.27% and he reported $56,920 as gain.

In 2009 the buyers defaulted and the property returned to DeBough. It cost him $3,723 in fees to reacquire the property. He then held on to the property.

What is DeBough’s income?

Here is his calculation:

Original gain

157,796
Reported to-date
(56,920)
Cost of foreclosure
(3,723)


97,153

I don’t think so, said the IRS. Here is their calculation:

Cash received

505,000
Reported to-date
(56,920)


448,080

DeBough was outraged. He wanted to know what the IRS had done with his $500,000 exclusion.

The IRS trotted out Section 1038(e):
         (e)  Principal residences.
If-
(1) subsection (a) applies to a reacquisition of real property with respect to the sale of which gain was not recognized under section 121 (relating to gain on sale of principal residence); and
(2)  within 1 year after the date of the reacquisition of such property by the seller, such property is resold by him,
then, under regulations prescribed by the Secretary, subsections (b) , (c) , and (d) of this section shall not apply to the reacquisition of such property and, for purposes of applying section 121 , the resale of such property shall be treated as a part of the transaction constituting the original sale of such property.

DeBough was not happy about that “I year after the date of the reacquisition” language. However, he pointed out, it does not technically say that the $500,000 is NOT AVAILABLE if the property is NOT SOLD WITHIN ONE YEAR.

I give him credit. He is a lawyer by temperament, apparently.  DeBough could find actionable language on the back of a baseball card.

It was an uphill climb. Still, others have pulled it off, so maybe he had a chance.

The Court observed that there is no explanation in the legislative history why Congress limited the exclusion to sellers who resell within one year of reacquisition. Still, it seemed clear that Congress did in fact limit the exclusion, so the “why” was going to have to wait for another day.

DeBough lost his case. He owed tax.

And the Court was right. The general rule – when the property returned to DeBough – is that every dollar DeBough received was taxable income, reduced by any gain previously taxed and limited to the overall gain from the sale. DeBough was back to where he was before, except that he received $505,000 in the interim. The IRS wanted its cut of the $505,000.

Yes, Congress put an exception in there should the property be resold within one year. The offset – although unspoken – is that the seller can claim the $500,000 exclusion, but he/she claims it on the first sale, not the second. One cannot keep claiming the $500,000 over and over again on the same property.

Since Debough did not sell within one year, he will claim the $500,000 when he sells the property a second time.

When you look at it that way, he is not out anything. He will have his day, but that day has to wait until he sells the property again.

And there is an example of tax law. Congress put in an exception to a rule, but even the Court cannot tell you what Congress was thinking.