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.

Caught In A (IRS Mortgage) Trap

Sometimes it seems that the tax Code is a trap waiting to spring on some unfortunate.  This time let’s talk about a trap involving mortgages.

(1) Chris and Jennifer bought a house in 2001 for $365,000.

(2) In 2003 they borrowed money ($427,333) from Jennifer’s mom. The note carried interest of 4.5%, and there was a document titled “Mortgage Note.”

(3) They also signed a second document titled “Mortgage.” This document included the following language:

“… hereby grant, convey and assign to … the property with the address of …..”

The document was signed, but it was not notarized or recorded at the courthouse.

(4) In 2008 Chris and Jennifer borrowed $200,000 from a bank. The bank required a note and mortgage. The bank recorded the mortgage.

(5) In 2009 Chris and Jennifer paid her mom $19,320 on her note and the bank $1,138 on theirs. They deducted the sum ($20,368) as mortgage interest on their tax return.

(7) The IRS audited their 2009 return.

What is there to look at?

The Code does not allow one to deduct personal interest. It used to, and people could deduct interest on their car loans and credit cards. That law changed in 1986, and the Code now restricts which types of interest are deductible.

One type is qualified residence interest. This is interest paid or accrued during the taxable year on acquisition indebtedness or home equity indebtedness secured by the qualified residence of the taxpayer. You and I call that a mortgage.

On first impression, it seems that Chris and Jennifer met this requirement.

Let’s look further at the definition of “acquisition indebtedness”:

(i)       In general – The term “acquisition indebtedness” means any indebtedness which –

(I)                Is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and

(II)             Is secured by such residence.

Regulation 1.163-10T(o) defines secured debt as “… recorded, where permitted, or is otherwise perfected in accordance with applicable State law.’

There is the trap. 

The debt has to be “perfected” under state law. The concept of “perfected” means that the secured creditor has a preferred position relative to an unsecured (or perhaps just a later) creditor. The money from that house goes to that mortgage holder, as he/she is first in line. Anyone else has to wait his/her turn.

Chris and Jennifer lived in Massachusetts, which requires a mortgage be recorded at the courthouse to be “perfected.”

Let’s start the unraveling:

(1) The mortgage was not perfected, meaning

(2) The debt to mom could not be “acquisition indebtedness,” meaning

(3) The interest on the debt could not be mortgage interest

The IRS – adding to its reputation of stabbing the dead – also charged Chris and Jennifer with the accuracy penalty. This is a “super” penalty and applies when the error trips certain dollar or percentage thresholds.

I cannot help but feel that the penalty was unnecessary. Is the IRS expecting people to be tax pros before they can fill-out their own tax returns? What are they going to do with me if I make a mistake on my return – shoot me?

I worry about this mortgage trap when working with intrafamily loans involving someone’s house. It can be tempting to cheat on attorney fees and not properly document or record the loan and mortgage.

If audited, one can expect the IRS to be as sympathetic to them as the IRS was to Chris and Jennifer.

A Waitress, A Waffle House And A Lottery Ticket

It’s fun to think about winning the lottery

There is a (former) waitress in Grand Bay, Alabama who did. She worked at a Waffle House. Enter Edward Seward, a regular at the restaurant. Seward liked the lottery. As Alabama did not have a lottery, he would travel to Florida to buy tickets. He also liked giving away the lottery tickets to the waitresses at the Waffle House. Our protagonist – Tonda Lynn Dickerson – had an agreement with four other waitresses that – if they ever won – they would share the winnings equally.

Would you know that the lottery ship docked, and Tonda Lynn had the winning ticket? The winnings were more than $9 million if paid out over 30 years, and over $5 million if paid in lump sum. First thing Tonda did was quit her job.

Tonda Lynn took the matter to her dad – Bobby Reece. Turns out her family was quite close and had talked about sharing lottery winnings if ever anyone won. Bobby seemed the most invested in the lottery discussion. Johnny Reece - the brother - was not so much into it.   

Bobby contacted Louisa Warren, the general counsel for the Florida Lottery Commission. Bobby explained the family understanding about the lottery. She told Bobby:

Don’t sign that ticket, period.”

She recommended that they form an entity to claim the winnings.

Enter an attorney and an S Corporation named 9 Mill, Inc.

NOTE: Get it?

Bobby sat down at the table and decided the ownership percentages while Tonda Lynn and her husband went car shopping. Turns out that Tonda and James (the husband) owned 49% of 9 Mill, Inc.

OBSERVATION: Bobby seems to have an intuitive grasp of tax issues.

Bobby and Mrs. Reece and James went to Florida to claim the ticket. They decided to take a 30-year payout of $354,000 per year.

... and they were notified of a competing claim against the winnings.

Remember the other waitresses at the Waffle House? They lawyered up. Their attorney filed suit in the Circuit Court of Mobile County, claiming that his clients were entitled to 80% of the winnings. The waitresses had an agreement. They also had a witness – Mr. Seward – who started the whole thing by giving Tonda Lynn the lottery ticket.

Tonda seemed to have forgotten any agreement, any Waffle House, any other waitresses. She had bought the ticket herself, it seems. There was a small problem with that, however. The tickets were sequentially numbered at the bottom, and her ticket – number 18 – was missing

The Circuit Court entered an order saying that the other four waitresses were right and that Tonda Lynn had to part with 80%.

Well, 9 Mill, Inc was not going to stand for that. They countersued, and the case went to the Alabama Supreme Court. The Supreme Court overturned the Circuit Court.

Tonda Lynn was back in the money, but not for the reason that you may think. The Court agreed that there was an agreement between the five waitresses, but the Court also pointed out that it could not enforce that agreement on public policy grounds. Alabama could not enforce a contract based on gambling. Gambling was not allowed in Alabama.

I suspect that Tonda Lynn can never go back to that Waffle House.

Not too long after, the IRS contacted Tonda Lynn. The IRS wanted its gift tax – approximately $770,000.

Tonda Lynn had a lottery ticket.  The winnings went into an entity of which she and her husband owned 49%. What happened to the other 51%? According to the IRS, Tonda Lynn must have gifted it.

You have to admit, they have a point.

Now Tonda Lynn and the IRS go to Court. She presents two arguments:

(1)     No gift occurred because at the time of transfer there existed an enforceable contract under Alabama law.

(2)     Alternatively, she and her family were all members of an existing partnership that was the true owner of the lottery ticket.

Let’s address this in reverse order.

The Court noted that the partnership, if one existed, was an odd partnership because it did not observe the formalities of a business activity. Ownership had never been spelled out, for example. The members were not required to contribute to the partnership or to buy lottery tickets regularly. A family member did not even know if another member bought a lottery ticket. There may have been an understanding, but that understanding did not rise to the level of an”activity” which could be housed in an entity.

Additionally, Tonda did not buy the ticket. It was given to Tonda, who would still have to explain how the ticket got into the entity.

On the first argument the Court reminded Tonda that there could have been no enforceable contract.  Alabama did not recognize gambling.

NOTE: Odd that Tonda Lynn would forget this, as this is the same reason Tonda won her case against the other waitresses. Short memory, I suppose.

Tonda Lynn owed gift tax.

The story is not done, though. There was one more issue before the court.

It turns out that the delay in cashing the winning ticket was a tax boon to Tonda, as it allowed time for the other waitresses to submit their claim. Had they not, then Tonda would have owed gift tax of approximately $770,000. The claim introduced uncertainty about the value of the gift. What would an independent party pay for that ticket at that moment, knowing there was a cloud, the resolution of which could mean forfeiture of 80% of the winnings?

The Court discounted the gift by more than two-thirds.

It was Tonda Lynn’s only victory with the IRS.

How did it turn out for Tonda Lynn? Her husband divorced her. He then supposedly kidnapped her.  She later declared Chapter 13 bankruptcy.

Do you still want to win the lottery?