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 (75^th Place) in 1997.

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

Renovations to 75^th Place were completed in 2010.

In 2011 they received an unwanted telephone call from their insurance agent. Someone had to live at 75^th 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 75^th 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 1^st, 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.

Is It A Bad Thing To Be A Resident Of Two States At The Same Time?

A state tax issue came up with a client recently, and I was somewhat surprised by another CPA’s response.  The issue arises when someone has tons of interest and dividend income – that is, big bucks, laden with loot, banking the Benjamins.  Since I consider myself a future lottery winner, it also means something to me.

Here it is:

           

Can you be a resident of two states at the same time?

The other CPA did not think it possible.

There are a couple of terms in this area that we should review: domicile and place of abode. Granted in most cases they would mean the same thing. For the average person domicile is where you live. You are a resident of where your domicile is located. We future lottery winners however frequently will have multiple homes.   I intend to have a winter home (New Mexico comes to mind), a summer home (I am thinking Hawaii) and, of course, one or more homes overseas. Which one is my domicile? Now the issue is not so clear-cut.

OBSERVATION: Let’s be honest: this is a high-end tax problem.

Domicile is your permanent home. It is the place to which you intend to return when absent, to which your memories return when away, it is home and hearth, raising children, Christmas mornings and planting young trees There can be only one. A domicile exists until it is superseded, and there can never be two concurrent domiciles. It is Ithaca to Odysseus. It took Odysseus ten years to get home from Troy, but his domicile was always Ithaca. The concept borders on the mystical.

A place of abode can be an apartment, a cottage, a yacht, a detached single-family residence. There can be more than one. I intend to have abodes in New Mexico, Hawaii and possibly Ireland. My wife may pick out another one or two.

Most states (approximately 30, I believe) use the concept of “domicile” to determine whether you are or are not a “resident” of the state. You can generally plan for these states by pinning down someone’s “main” house.  A state can tax all the income of a resident, which is what sets up the tax issue we are talking about.

Then you have the “statutory” states, among the most aggressive of which is New York. New York will consider you a resident if:

(a)  Your domicile is New York, or

(b) Your domicile is not New York, but

a.     You maintain a permanent abode in New York for more than 11 months of the year, and

b.     You spend more than 183 days in New York during the year

That “or” is not there because New York wants to be your friend. That (b) is referred to as statutory residency. It is intentional, and its intent is to lift your wallet.

How? It has to do with all those interest and dividends we future lottery winners will someday have.

Let’s say that you live in Connecticut and work in White Plains. You are going to easily meet the “more than 183 days in New York” test. Unless you work at home. A lot. Let’s say you don’t.

We next have to review if you have a “permanent abode.” What if you have a vacation home in the Hamptons. What if you have an apartment in Brooklyn. What if you rent an apartment (in your name) for your daughter while she is attending Syracuse University. Do you have a permanent abode in New York? You bet you do. The “permanent” just means that it can be used over four seasons. We already discussed the meaning of “abode.”

Think about that for a moment. You may never stay at your daughter’s apartment. It will however be enough for New York to drag you in as a statutory resident because you “maintain” it.  New York doesn’t care if you ever actually stay there – or even step foot in it.

Great. You are a resident of both Connecticut and New York.

So what, you think. Connecticut will give you a credit for taxes paid New York. New York will give you a credit for taxes paid Connecticut. The accountants’ fee will be wicked, but you are not otherwise “out” anything, right?

Wrong. You may be “out” a lot, and it has to do with those interest and dividends and royalties and capital gains – that is, your “investment income.”

There is a state tax concept called “mobilia sequuntur personam.” It means “movables follow the person,” and in the tax universe it means that movable income (think investment income, which can be “moved” to anywhere on the planet) is taxed only by one’s state of residence. The system works well enough when there is only one state in the picture. It may not work so well when there are two states.

The reason is the common technical wording for the state resident tax credit. Let’s look at New York’s wording as our example:

A resident shall be allowed a credit …for any income tax imposed for the taxable year by another state …. upon income both derived therefrom and subject to tax under this article."

The trap here is the phrase “derived therefrom.” Let’s trudge through a New York tax Regulation to see this jargon in its natural environment:

           

The term income derived from sources within another state … is construed as ... compensation for personal services performed in the other jurisdiction, income from a trade, business or profession carried on in the other jurisdiction, and income from real or tangible personal property situated in the other jurisdiction."

Well, isn’t that a peach? New York wants my interest and dividend income to be from personal services I perform (that’s a “no”), from a trade, business or profession (another “no”) or from real or tangible property (again a “no”).

New York will not give me a resident credit for taxes paid Connecticut.

That means double state taxation. 

Yippee.

Can this be constitutional? Yes, unfortunately. The Supreme Court long ago decided that the constitution does not prohibit two states reaching the conclusion that each is the taxpayer’s state of residence. The Court stated:

“[n]either the Fourteenth Amendment nor the full faith and credit clause … requires uniformity of different States as to the place of domicile, where the exertion of state power is dependent upon domicile within its boundaries.” (Worcester County Trust Co v Riley)

What did we advise? The obvious advice: do NOT be in New York for more than 183 days in a calendar year NO MATTER WHAT. 

Our client’s apartment is in Manhattan, so she also gets to pay taxes to New York City on top of the taxes to New York State. I hope she really likes that apartment.

BTW New York is NOT on my list of states for when that future lottery comes in.