A Condo Association, Dogs Running Wild and An Office In Home

This time we are talking about an office-in-home. Many of us have one, but few of us can actually claim a tax deduction for it.

The office-in-home deduction has five main rules, two of which are highly specialized. The remaining three require one to:

1. Use the office exclusively and regularly as a principal place of business
2. Use the office exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of business
3. Use the office in connection with a trade or business – but only if the office is a separate structure

If you are an employee, then you are in the trade or business of being an employee. If your office is in a separate structure, you are home-free under test (3). 

OBSERVATION: I suppose a converted, oversized shed could meet this test.   

I have a CPA friend who practices out of her basement. She would qualify under test (2), as she regularly meets with her clients there. I however almost always meet clients either at their office or mine, so I would not qualify.

That leaves us with test (1), which is an almost impossible standard to meet if one has an office elsewhere. Fortunately there was a Supreme Court decision a number of years ago (Soliman), which allowed one to consider administrative or management duties for purposes of this test.  

Soliman was an anesthesiologist, and the three hospitals where he worked did not provide him with an office. He used a spare bedroom for work-related activities, such as contacting patients and billing. The IRS had previously taken a very hard line with test (1) and denied the deduction. The IRS reasoned that Soliman’s job was to put people to sleep, and he did that job at the hospital. This meant that the hospital was his “principal” place of business.  The IRS was not going to be persuaded otherwise, at least until the Supreme Court told them to knock it off and allow Soliman his deduction.

Great. So I can do administrative work at home – such as scheduling or billing – and have my office qualify for a deduction, right?

Not so fast.

There are two more tests if one is an employee. The one that concerns us is the requirement that the office be for the convenience of the employer.

Those words sound innocuous, but they are not.

For most of us, having an office at home is for our convenience. In fact, the IRS takes this farther, arguing that – if your employer provides you with an office – then it is virtually impossible for the home office to be for the employer’s convenience.  The IRS reasons that the employer would not care if you showed up, as it had an office waiting. There are some exceptions, such as telecommuting or requiring work hours when the office is closed, but you get the idea. For the vast majority of employees, one cannot get past that convenience-of-employer test.

What if one is self-employed? Forget the convenience test. There is no employer.

Let’s look at McMillan v Commissioner. There will be a quiz at the end.

Denise McMillan had a couple of things going on, but what we are interested in is her home office. She was self-employed.

She claimed an office-in-home deduction on her 2009 return. I am not certain of her housing situation, but her office was 50% of her home. I cannot easily visualize how this is possible, especially given the requirement that the office space not be used for any other purpose. That is a lot of space that she is not using for another purpose – like living there.

She lived in a condo. She had gotten into it with the homeowners association over construction defects related to mold and noise, dogs running wild, dogs barking incessantly and leaving dog memorabilia as dogs will when running wild and barking nonstop.

The condo association would do nothing, so she sued them.

The condo association – highlighting the quality of its Board – sued her back.

Wow, send me a flyer so I can consider buying at this bus station to paradise.

All in all, she was out over $26 thousand in legal fees and expenses.

And she deducted 50% of them through her office-in-home deduction.

QUIZ: Is this a valid tax deduction?

She sued because of events which were interfering with her use and enjoyment of her property.  Had this property been exclusively her residence, the conversation would be over. But one-half of it was being used for business purposes.

She next had to show that the litigation also had an effect on her business activity.

 QUESTION: Have you decided yet?

The Court observed that she was suing over noise, animal waste and similar issues. She argued that they were affecting her ability to work. Makes sense to me.

The IRS did not challenge her argument. 

NOTE: My hunch is that the IRS was relying upon an origin-of-claim doctrine. The lawsuit originated from a personal asset – her residence – so the tax consequences therefrom should remain personal. In this case, personal means nondeductible.

Since the IRS did not challenge, the Court could not – or would not - conclude that there was no effect on her ability to work.

The IRS had not challenged the 50% percentage either.

So the Court decided that she was entitled to a tax deduction for 50% of her legal expenses.

By the way, how did you answer?

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.

How An Estate Can Lose A Charitable Deduction

It happened again this week. I was speaking with another accountant when he raised a tax question concerning an “estate” return. My stock question to him was whether it was an “estate fiduciary” or an “estate estate.” Both have the word “estate” in it, so one needs further clarification.

What is the difference?

If one dies with too many assets, then the government requires one to pay taxes on the transfer of assets to the next person. This is sometimes referred to as the “death” tax, and I sometimes refer to it as the “estate estate” tax.

It has gotten a little more difficult to trigger the federal estate tax, as the taxable threshold has been raised to over $5 million. That pretty much clears out most folk.

Then you can have the issue of the estate earning income. How can this happen? An easy way is to own stock, or a business – or perhaps a part of a business through a partnership or S corporation. That income will belong to the estate until the business is transferred to the beneficiary. That may require a trip to probate court, getting on the docket, waiting on the judge…. In the interim the estate has income.

And what do you have when an estate has income? You have an income tax return, of course. There is no way the government is not going to grab its share. I sometimes refer to that tax return as the “estate fiduciary.” A trust is a fiduciary, for example. The estate is behaving as a fiduciary because it is handling money that belongs to other people – the same as a trust.

Say that an estate receives a disbursement from someone’s 401(k). That represents income. This is usually a significant amount, and Hamilton’s Third Theorem states that a percentage of a significant number is likely to also be a significant number. This seems to always come as a surprise when the attorney fires over an estate’s paperwork – usually very near the filing due date – with the expectation that I “take care of it.”

Then we are looking for deductions.

A fiduciary has a deduction called an “income distribution,” which I rely upon heavily in situations like this. We will not dwell on it, other than to say that the fiduciary may be allowed a deduction when he/she writes a check to a beneficiary.

No, the deduction I want to talk about today is about a contribution to charity.  Does our “estate fiduciary” get a deduction for a charity? You bet.

Let’s take this a step further. What if the estate intends to write a check to charity but it cannot just yet? Can it still get a deduction?

Yep.

This is a different rule than for you and me, folks. The estate has a more lenient rule because it may have to wait on a court hearing and receive a judge’s approval before writing that check. The IRS – acknowledging that this could wreak havoc on claiming deductions – grants a little leeway.

But only a little. This rule is known as the “set aside,” and one must meet three requirements:

(1)   The contribution is coming from estate income (that is, not from estate corpus)

(2)   The contribution must be allowed by estate organizing documents (like a will), and

(3)    The money must be permanently set aside, meaning that the likelihood that it would not be used as intended is negligible.

So, if we can clear the above three requirements – and the estate intends to make a contribution – then the estate has a possible deduction against that 401(k) distribution that I learned about only two or three days before the return is due.

What can go wrong?

One can flub the “negligible” requirement.

I cannot remember the last time I read about a case where someone flubbed this test, but I have recently finished reading one.

The decedent (Ms Belmont) passed way with a quarter million in her 401(k) and a condo in California. She lived in Ohio.

Alright, there is more than one state involved. It is a pain but it happens all the time.

Her brother lived in the condo. He was to receive approximately $50,000, with the bulk of the estate going to charity. He was under mental care, so there may have been a disability involved.

How can this blow up? Her brother did not want to move out of the house. He offered to exchange his $50,000 for a life estate. He really wanted to stay in that house.

The charity on the other hand did not want to be a landlord.

Her brother brought action and litigation. He argued that he had a life estate, and he was being deprived of his contractual rights.  He filed with the Los Angeles County Probate Court and the California Recorder’s Office.  

Meanwhile the estate fiduciary return was due. There was a big old number in there for the 401(k) distribution. The accountant – who somehow was not fully informed of developing events in California – claimed a charitable contribution deduction using the “set aside” doctrine.

The California court decided in the brother’s favor and orders a life estate to him and a remainder deed to the charity.

The estate thinks to itself, “what are the odds?” It keeps that set aside deduction on the estate fiduciary return though.

The IRS thinks otherwise. It points out that the brother was hip deep by the time the accountant prepared the return, and the argument that risks to the set aside were “negligible” were unreasonable when he was opening up all the guns to obtain that life estate.

The estate lost and the IRS  won. Under Hamilton’s Third Theorem, there was a big check due.

What do I see here? There was a tax flub, but I suspect that the underlying issue was non-tax related. Likely Ms Belmont expected to outlive her brother, especially if he was disabled. It did not occur to her to plan for the contingency that she might pass away first, or that he might contest a life estate in the house where he took care of their mom up to her death while his sister was in Ohio.