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.
