Is It A Second Home Or A Rental?

There are certain tax issues that seem to repeat in practice.

A client asked me how we handled his rental this year.  The answer was that we had stopped treating it as a rental in 2013. He was no longer renting the property. It needed repairs, and he was saving money to fix it up. He intended to then let his son live there.

There comes a point – if one does not rent – that it is no longer a rental. It may have been a rental once, in the same capacity that we once played football or ran track in high school. We did but no longer do. We are no longer athletes. We certainly are no longer young.

Let’s tweak this a bit: when does a property first start as a rental?

Obviously, when you first rent it.

What if you can’t rent it?

You would answer that you would not have bought a property that you couldn’t rent, so the scenario doesn’t make sense. It is the tax equivalent of the Kobayashi Maru.

What if you owned the property as a non-rental but decided to convert it to a rental? You didn’t actually rent it, unfortunately, but in your mind you had converted it to a rental.

But is it a rental or is it not?

Granted, the passive loss rules have put a dampener on this tax issue, as one is allowed to deduct passive losses only to the extent of passive income. There is a break for taxpayers with income less than $150 thousand, but it is quite likely that someone with this tax issue has income beyond that range. There is still a tax bang when you sell the property, though, regardless of your income.

The Redisch case takes us to Florida. We are talking about second homes.

The Redisches are Michigan residents. They bought land in a private oceanfront community (Hammock Dunes) in Palm Coast, Florida. They rented an oceanfront condo while meeting with an architect for ideas for building on the land. They decided they liked oceanfront more than non-oceanfront, so they sold the land in 2003 and bought an oceanfront condo in 2004. It must have been a very nice condo, as it cost $875,000.

The condo was their second home, and they often spent time there with their daughter.

Their daughter passed away tragically in 2006.

The Redisches could not stay at the condo any more. The memories were too painful.

In 2008 they decided to sell the condo. You may remember that 2008 was a very bad year for real estate. They decided instead to rent the property for a while and allow the market to recover.

They contacted a realtor associated with Hammock Dunes to market the rental. Hammock Dunes itself was still under development, so any potential sale of the condo would have been competing with new construction. Renting made sense.

The Redisches hired a realty company. They figured they had gotten an edge, as most of the company realtors lived in Hammock Dunes themselves. The company operated an information center there, which would help to market their rental. The realty company even used the condo as a model, although they did not pay the Redisches for such use. They did however persuade the Redisches to change one of the bedrooms to a child’s room. There was hope that someone with a child (or, more likely, a grandchild) would be interested.

The Redisches received a couple of inquiries. One person wanted to rent the property for two months, but the condo association did not permit short-term rentals. The other person had a big dog, which also ran afoul of condo restrictions.

It was now a year later and the rental effort was going nowhere. Other owners in Hammock Dunes were losing their properties to foreclosure. The Redisches were becoming keenly concerned with selling the property while there was still something to sell. They switched realty companies. They had the property reappraised. They dropped to price to $725,000 and finally sold the condo in December 2010.

They claimed the condo as a rental on their 2009 and 2010 tax returns. They reported a long-term capital loss on the sale of the property. 

OBSERVATION: Which is incorrect. If the property was a rental, the loss would be a Section 1231 transaction, reportable as an ordinary loss on the tax return. If the property was a second home, then any loss would be disallowed.

And the IRS looked at their 2009 and 2010 tax returns.

The tax issue was whether the property was a rental.

What do you think: did the Redisches do enough to convert the property to a rental?

One the one hand, they had a valid non-tax reason to sell the property. There was a business-like reason to withdraw it from the market and rent it instead. They hired experts to help with the rental. They transacted with potential renters, but condo restrictions disallowed those specific rentals. What more could they do, as they themselves were living in Michigan?

On the other hand, the IRS wondered why they did not try harder. After all, if one’s trade or business is renting real property, then one goes to great lengths to, you know, rent real property. The IRS wanted to see effort as though the Redisches’ next meal depended on it.

Here is the Court:

After considering all the facts and circumstances, we find that the […] property was not converted to a rental property. The Redisches used the property for four years before abandoning personal use of it …. Although Mr. Redisch testified that he signed a one-year agreement with a realty company […], he did not provide any other evidence of such an agreement. Even if the Redisches had produced the contract, Mr. Redisch stated that the efforts of the realty company to rent out the Porto Mar property were limited to featuring it in a portfolio kept in the company’s office and telling prospective buyers that it was available when showing it as a model. 

It is unsurprising that this minimal effort yielded only minimal interest.”

Ouch.

The Court decided that the Redisches were not acting in a business appropriate manner, if their business was that of renting real property. The Court unfortunately did not indicate what they could have done that would have persuaded it otherwise. Clearly, just hoping that a renter would appear was not sufficient.

Ohio Reforms Its Local Income Taxation

I remember having to quickly ramp-up on local taxes after moving to Cincinnati. I grew up in Florida, which has no state or local individual income taxes. We moved here from Georgia, which has a state but no local income taxes. I did not realize at the time that I was moving to a region which has approximately 80% or more of all the local income taxes in the nation – Ohio, Indiana, Pennsylvania and Kentucky.

The Kentucky local individual taxes are – for the most part – occupational taxes. If you do not work in one of those counties or cities, you generally do not have to worry about it. I live in Kentucky, for example, but I pay no Kentucky local income taxes. I do not work in Kentucky.

Indiana has county taxes, but they are filed with the state individual income tax return. Think of it as a “piggy-back” tax.

Ohio had to be different. For one thing, Ohio cities tax their residents, meaning that – if you live within the city – you have yet one more tax return to file. It doesn’t matter whether you work there (in contrast to Kentucky), and in many cases you have to file a return whether you owe tax or not. You might not owe tax, for example, if the city allows (at least some) credit for the local taxes paid to the city where you work (for example, if you live in a suburb but work downtown).

Add to this that each city has local autonomy to determine its taxable base, within the limits of Ohio law. One city could tax supplemental retirement benefits (SERPs), while another would not. One city could allow you to carry over a net operating loss (NOL) to future years, while another city would not.  Even if the city allowed an NOL, your city might allow a carryover of five years, while another would allow only three.

Even for a tax pro, it is a pain.

On December 19, 2014 the Governor signed a bill that promises to bring some standardization to the wild west of Ohio local income taxation. It is called the Ohio Municipal Income Tax Reform Act, and it will be effective for tax years beginning on and after January 1, 2016. The delay was intentional, as tax forms may need to be redesigned and instructions updated. A tax bill signed in December does not leave much time for that. 

Let’s go over the high points:

(1) The calculation of local taxable income will begin with federal adjusted gross income. The adjustments to federal AGI have been significantly standardized and include, for example, interest, dividends and capital gains.

NOTE: There are two cities in Ohio that start with Ohio adjusted gross income (from the Ohio state income tax return). Those two do not have to change to the new law. One of them is in Cincinnati and rhymes with Indian Hill. The effect for residents of Indian Hill is to tax their interest, dividends and capital gains. 

(2) Partnerships and LLCs will be taxed at the entity level only. Partners and members will subtract this income (as an adjustment under (1) above) when calculating their city tax.

That leaves Subchapter S shareholders to discuss.

(3) Subchapter S corporations will also be taxed at the entity level.

In addition, S shareholders may also continue to be taxed at the individual level if they live within 119 selected municipalities.

OBSERVATION: Obviously not as good as the rule for partnerships and LLCs. Why the difference? Who knows.          

(4) Losses from a passthrough entity (that is, a partnership, LLC, Subchapter S or (unlikely) a trust) may offset self-employment, rental, royalty and farming income. The reverse is also true.

(5) Net losses from (4) however cannot offset wages and salaries.

(6) Employee business expenses (that is, “Form 2106” expenses) will be deductible to the extent deducted for federal purposes.

(7) Ohio cities will have to limit their consideration of “domicile” to 25 common law-type tests. The cities are not permitted to add to these 25 tests.

NOTE: This is the “snowbird” test. I have had cities tell me they do not recognize snowbirds. A house there means you are taxed there, whether you spend much time at the house or not.

(8) An employee or sole proprietor is allowed to go into and out of a city for up to 20 days without triggering withholding for that city’s income tax.

NOTE: The previous threshold was 12 days. Notice that we are discussing withholding taxes only. A city may still contact a business for business income taxes if it spots business vans and work trucks stopping within the city.

(9) Pensions are not taxable.

NOTE: SERPs are considered to be wages, not pensions. SERPS are deferred compensation plans, usually funded exclusively by the employer. The tax reporting for a SERP is done on Form W-2 - the same reporting as one's wages or salary - so the cities take the position that SERPs are wages and not pension income.

(10)        Returns will be due (for a calendar year taxpayer) on April 15.

(11)        The returns will be automatically extended if a federal extension is requested.

(12)        Estimated individual income taxes will be required only if the estimated tax due is $200 or more.

(13)        Any tax due (before withholdings or estimates) of $10 or less will be reduced to zero.

NOTE: You still have to file the tax return, though.

(14)        Any interest due will charged at the federal rate plus 5% (Ohio’s rate is federal plus 3%).

(15)        Net operating losses are standardized.

a.     Beginning January 1, 2017 all cities will allow a uniform 5-year carryover (with a phase-in).

b.     Earlier NOLs will be permitted as allowed by pre-change city law.

c.      City NOLs will be calculated using federal limitations such as passive activity, basis or at-risk limitations.

NOTE: This is a subtle but very significant change – in favor of the cities.

(16)        Certain administrative changes, such as requiring the cities to send out an assessment notice -clearly marked “ASSESSMENT” – before they can change your numbers on the city return.

The Ohio Society of CPAs was an outspoken advocate of these changes. I am  sympathetic to arguments the cities raised, but I am nonetheless thankful for some standardization. I prepare or review local returns. I have to bill for this, as this is my profession. I have routinely seen business clients with multiple local returns where the cumulative tax is a fraction of the professional fee to prepare the returns. I submit that a tax is unfair when the preparation fee routinely exceeds any tax so raised. Call it Hamilton's razor if you wish. 

By the way, I would apply the same razor to federal and state taxes. A corollary to the razor would require Congress to reduce its revenue estimates from any proposed tax by the compliance costs (that is, the professional fees) of complying with said proposed tax. I suspect we wouldn't see as much nonsense as we presently have in the tax Code.
 

If I Had A Pony, I Would Ride It On My (Tug) Boat

If you have a business, and especially if that business has real estate, odds are very good that your tax advisor will talk to you about the “repair regulations” this filing season.

The IRS and taxpayers have spent decades arguing and going to court over whether an expenditure is a repair (and immediately deductible) or a capital improvement (which cannot be deducted immediately but rather must be depreciated over time). Eventually the IRS decided to pull back, review the existing court cases and develop some rhyme or reason for tax practice in this area. They were at it for years and years.

And now we have the “repair regulations.”

I debated whether to write on this topic, as one can leave the pavement and get lost in the weeds very quickly. It is like a romper room for tax nerds. Still, we have to at least discuss the high points.

Let’s set this up. Say that you have a tug boat. The boat is expected to last you approximately 40 years, if you maintain and keep it up. Every 4 or so years, you anchor the tug and give it a good overhaul, replace what needs replacing and rebuild the engine. This is going to cost you well over $100 grand.

Question: is this a repair (hence deductible) or a capital improvement (not immediately deductible but depreciable over time)?

It is not immediately clear. This costs a lot of money, so one’s first response is that it has to be capitalized and depreciated. However, regular use of a tug presumes heavy maintenance of this kind over its life. That sounds more like a repair expense.

The IRS has introduced the concept of a unit of property. We have to base the repair versus capitalization decision on the unit of property. Is the engine the unit of property (UOP) or is it the overall boat?

The main test for UOP is “functional interdependence.” The placing in service of one thing depends on the placing in service of something else.

Well, a tug boat engine without a tug boat to put it in is not of much use to anybody, so we would say that the overall boat is the unit of property.

Progress. Do we now know whether to capitalize or deduct the engine?

Nope.

Onward.

We next climb through a fence we will call the “BAR,” which stands for

·        Betterment

·        Adaptation

·        Restoration

If you get stuck on any rung of the “BAR,” you have to capitalize the cost. Sorry.

Let’s have a quick peek at which each term means:

·        Betterment

o   You made the thing larger, stronger, more efficient.

We did not turn the thing into a “monster” tug. Let’s move on.

·        Adaptation

o   You tweaked the thing for a different use or purpose.

Nope. It’s still a tug. Can’t fly it or drive it on a highway.

·        Restoration

o   Returning the thing to a usable condition after you have run it into the ground, either because you neglected it (and it fell apart) or it just got too old.      

Doesn’t sound like it. We are not neglecting the tug in any way, and it still has many years of use left.

This is looking pretty good for our tug.

Let’s go through a few more rules, just in case.

If your CPA prepares audited financial statements for you, the IRS will not challenge your deducting something up to $5,000 as a repair as long as you did the same thing on your financial statements.  

That tug thing costs way more than $5,000. Let’s continue. 

NOTE: BTW, if you do not have an audit, the IRS drops that dollar limit down to $500.

If we are talking about “materials and supplies,” the IRS will not challenge your deducting something as long as it costs $200 or less. Fuel for that tug would be considered “materials and supplies.” 

That tug work blew past $200 like it was standing still. Let’s proceed.

If you capitalize the thing on your books and records, the IRS will not argue that you should have deducted it instead.

            Downright charitable of them. Let’s move on.

If a repair is expected to be done more than once over the life of the UOP, then the IRS will not challenge your deducting it as a repair.

Whoa. We have something here. That boat is expected to last somewhere around four decades. The heavy maintenance has to be done every so many service hours, generally meaning every three or four years. Looks like we can deduct the repairs to our tug.

Let’s dock the tugboat and briefly discuss a building. Perhaps we can see our tug from our building.

The IRS is taking the position that a building is both one unit of property and more than one unit of property.

I do not make this up, folks.

The IRS wants certain systems of a building – like its HVAC or its elevators – to also be considered a separate UOP. Let’s take an example. Let’s say that you are replacing a bunch of windows on that building. You would then evaluate whether it is a repair or an improvement by reference to the building as a whole. This is a good thing, as it would take a lot to “improve” the building as a whole. This makes it more likely that the answer will be a deductible repair.

However, say that you replace an elevator. The IRS says that you have to look at elevators separately from the overall building. We’ll, it does not take much to improve an elevator if you are just comparing it to an elevator. This is a bad thing, as it makes it more likely that the result will be a capital improvement.

BTW there is a separate test if your building costs less than a $1 million when you bought it. The IRS will “spot” you a certain amount before it will challenge whether something is a repair or not. It’s for the smaller landlords, but it is something.

And there you have the highlights of the repair regulations.

Depending on your fact patterns, there may be elections and forms that you have to attach to your tax return. Your tax advisor may even request that you change your underlying bookkeeping – like expensing stuff under $5000/$500 on your general ledger, for example. Some of these will require extra work, and hence additional fees, by and from your advisor.

And there is one more thing.

Let’s go back to the tugboat.

Let’s say that you did the major overhaul four years ago and capitalized the cost. You are now deducting those repairs over time as depreciation. The new rules now allow you to deduct the cost immediately as a repair. Had we only known!

Is it too late for us? Four years back is one more year than the statute of limitations permits, so we cannot go back and amend your return.

The IRS – to their credit – realized the unfairness of this situation, and it will let you go back and apply these new rules to that old tax year. The IRS calls it a “partial disposition,” and you can deduct what’s left of that capitalized tugboat repair on your 2014 tax return. It is called a “Change in Accounting Method” and is yet another multi-page form with your return, but at least you can get the deduction. But only on 2014. Let it slip a year and you can forget about it.

If any of the above rings a bell, please discuss the “repair regulations” with your tax advisor. Seriously, after 2014 you may be stuck. Tax does not have to be fair.

Lyle Lovett - If I Had A Boat