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.

Why Does Arkansas Think You Would Pay Taxes Voluntarily?

“This appeal arises from a dispute of ad valorem taxes.”

Thus begins the Arkansas Supreme Court decision in Outdoor Cap Co v Benton County.

Outdoor Cap Co (Outdoor Cap) makes – as you can guess – caps and other headwear. They are located in Bentonville, where Walmart is headquartered.

Ad valorem taxes are paid on the value of real or personal property. An example is property taxes assessed on business equipment; another example would be the annual property taxes a Kentucky resident pays on his/her car

Outdoor Cap has been paying property taxes since 1976. In 2011 it filed for a refund of its 2008 and 2009 taxes. It wanted a refund of over $247,000.

The reason for the refund? They made a mistake. They paid taxes on their inventory and (some of) that inventory was entitled to a “freeport” exemption.

This is a term we have not discussed before. The easiest way to understand the freeport is to think of port cities. Products arrive on very large ships, are unloaded, catalogued, organized and prepared for continued transit.  It would be bad practice to levy customs and duties simply because the products arrived at that particular port. It would make more sense to allow the products to pass through without assessment, to instead be taxed at their ultimate destination.

Substitute property taxes for customs and duties and you have the “freeport” exemption.

So Outdoor Cap made a mistake when it filed its personal property taxes and now wants some of its money back.

Benton County said “no.”

Outdoor Cap kept pursuing this until it wound up in the Arkansas Supreme Court.

The first thing that occurred to me is that perhaps Outdoor Cap was outside the refund period – you know: the “statute of limitations.” You have to get a refund claim in within a certain period of time, because to keep the claim period open indefinitely would impair the administration of the tax system

I was wrong. This was not about the statute of limitations. This was about whether Outdoor Cap paid something that the state was required to repay.

Outdoor Cap made three arguments:

            (1) The property was exempt from taxation.

The property is not taxable because of the freehold, but does that mean that the property is “exempt?’

And we now enter the legal swamp of wordsmithing. Technically, under Arkansas law (Ark Code Ann 26-26-1102) a freehold does not mean that the property is not taxable. There are two steps before property can be taxed: first, the property must be taxable; second, the property must be located in Arkansas.

The Court determined that the freehold addressed the second test only: Arkansas did not consider the property as being in Arkansas. Had it been, it would have been taxable.

This is a fine weaving of words, but there it is. Outdoor Cap lost argument one.

(2) The property was erroneously assessed.

Arkansas law (Ark Code Ann 26-35-91) allows refunds only for erroneously assessed property.

 
Outdoor Cap of course argued that the property was erroneously assessed.

On first impression, this seems solid ground. Outdoor Cap argued that the property was misclassified and taxes were erroneously paid on it. Taxes have to be assessed before they can be paid. Otherwise, the tax would be paid voluntarily, which is nonsensical.

The Court made a distinction between an excessive assessment and an erroneous assessment. Outdoor Cap reported its property without claiming the freeport. There cannot be an erroneous assessment under law because the company did not provide all the information that Arkansas would need to realize that there was an error. Yes, the assessment was “excessive,” but it was not “erroneous.”

Outdoor Cap lost argument two.

(3)  Since tax was not actually due, the payment was a voluntary payment and the company wants its payment refunded.

Arkansas apparently allows for voluntary payments. What it won’t do is give you the money back, unless you can show that you are otherwise entitled to a refund.

This gets us back to what we said in argument (2): to get money back, one has to show that the taxes are “recoverable.” Arkansas allows only one definition of “recoverable”: there must have been an error in assessment.

Surely taxes can be recoverable if there was a mistake?

“The principle is an ancient one in the common law, and is of general application. Every man is supposed to know the law, and if he voluntarily makes a payment which the law would not compel him to make, he cannot afterwards assign his ignorance of the law as a reason why the State should furnish him with legal remedies to recover it back.”

In desperation Outdoor Cap tried a “Hail Mary,” arguing that it paid it taxes under “coercion,” because, if taxes were not paid, the County had the authority to take and sell the property.

“… the argument is without merit because every taxpayer would have been ‘coerced’ according to Outdoor Cap’s argument because every taxpayer would be subject to penalties if its taxes weren’t paid.”

The “Hail Mary” fell to the ground.

The Court decides that Outdoor Cap …

“… voluntarily paid its taxes for the years 2008 and 2009, and did not claim a manufacturer’s exemption for those years. It is presumed to have known the law and its rights under the law. Accordingly, we do not find error in the circuit court’s application of the voluntary payment doctrine….” 

Outdoor Cap lost argument three.

The Court finally decided there was no refund for Outdoor Cap.

My thoughts?

Technically, the Court was correct. It was an affront to common sense, however. I have been at this for thirty years, and I have yet to meet the first person who paid taxes “voluntarily.” I guess I could put it on my bucket list, along with “play in the NFL.”

As I have gotten older, I have come to view the presumption that one “know the law” to be the drool of a political overclass.  An army of attorneys could not keep track of every mandate, ordinance, diktat or regulation these politicians strew upon society. It might be more honest if they simply said “I win and you lose, because I say so.”

I think Outdoor Cap Co got hosed.

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 

How Choosing The Correct Court Made The Difference

I am looking at a District Court case worth discussing, if only for the refresher on how to select a court of venue. Let’s set it up.

ABC Beverage Corporation (ABC) makes and distributes soft drinks and non-alcoholic beverages for the Dr Pepper Snapple Group Inc. Through a subsidiary it acquired a company in Missouri. Shortly afterwards it determined that the lease it acquired was noneconomic. An appraisal determined that the fair market rent for the facility was approximately $356,000 per year, but the lease required annual rent of $1.1 million. The lease had an unexpired term of 40 years, so the total dollars under discussion were considerable.

The first thing you may wonder is why the lease could be so disadvantageous. There are any number of reasons. If one is distributing a high-weight low-value product (such as soft drinks), proximity to customers could be paramount. If one owns a franchise territory, one may be willing to pay a premium for the right road access. Perhaps one’s needs are so specific that the decision process compares the lease cost to the replacement cost of building a facility, which in turn may be even more expensive. There are multiple ways to get into this situation.

ABC obtained three appraisals, each of which valued the property without the lease at $2.75 million. With the lease the property was worth considerably more.

NOTE: Worth more to the landlord, of course. 

ABC approached the landlord and offered to buy the facility for $9 million. The landlord wanted $14.8 million. Eventually they agreed on $11 million. ABC capitalized the property at $2.75 million and deducted the $6.25 million difference.

How? ABC was looking at the Cleveland Allerton Hotel decision, a Sixth Circuit decision from 1948. In that case, a hotel operator had a disastrous lease, which it bought out. The IRS argued that that the entire buyout price should be capitalized and depreciated. The Circuit Court decided that only the fair market value of the property could be capitalized, and the rest could be deducted immediately. Since 1948, other courts have decided differently, including the Tax Court. One of the advantages of taking a case to Tax Court is that one does not have to pay the tax and then sue for refund. A Tax Court filing suspends the IRS’ ability to collect. The Tax Court is therefore the preferred venue for many if not most tax cases.

However and unfortunately for ABC, the Tax Court had decided opposite of Cleveland Allerton (CA), so there was virtually no point in taking the case there. ABC was in Michigan, which is in the Sixth Circuit. CA had been decided in the Sixth Circuit. To get the case into the District Court (and thus the Circuit), ABC would have to pay the tax and sue for refund. It did so.

The IRS came out with guns blazing. It pointed to Code Section 167(c)(2), which reads:

            (2) Special rule for property subject to lease

If any property is acquired subject to a lease—

(A) no portion of the adjusted basis shall be allocated to the leasehold interest, and

(B) the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease.

The IRS argued that the Section meant what it said, and that ABC had to capitalize the entire buyout, not just the fair market value.  It trotted out several cases, including Millinery Center and Woodward v Commissioner. It argued that the CA decision had been modified – to the point of reversal – over time. CA was no longer good precedent.

The IRS had a second argument: Section 167(c)(2) entered the tax Code after CA, with the presumption that it was addressing – and overturning – the CA decision.

The Circuit Court took a look at the cases. In Millinery Center, the Second Circuit refused to allow a deduction for the excess over fair market value. The Sixth Circuit pointed out that the Second Circuit had decided that way because the taxpayer had failed its responsibility of proving that the lease was burdensome. In other words, the taxpayer had not gotten to the evidentiary point where ABC was.

In Woodward the IRS argued that professional fees pursuant to a stockholder buyout had to be capitalized, as the underlying transaction was capital in nature. Any ancillary costs to the transaction (such as attorneys and accountants) likewise had to be capitalized. The Sixth Circuit pointed out the obvious: ABC was not deducting ancillary costs. ABC was deducting the transaction itself, so Woodward did not come into play.

The Court then looked at Section 167(c)(2) – “if property is acquired subject to a lease.” That wording is key, and the question is: when do you look at the property? If the Court looked before ABC bought out the lease, then the property was subject to a lease. If it looked after, then the property was not. The IRS of course argued that the correct time to look was before. The Court agreed that the wording was ambiguous.

The Court reasoned that a third party purchaser looking to acquire a building with an extant lease is different from a lessee purchaser. The third party acquires a building with an income stream – two distinct assets - whereas the lessee purchaser is paying to eliminate a liability – the lease. Had the lessee left the property and bought-out the lease, the buy-out would be deductible.

The Court decided that the time to look was after. There was no lease, as ABC at that point had unified its fee simple interest. Section 167(c)(2) did not apply, and ABC could deduct the $6.25 million. The Court decided that its CA decision from 1948 was still precedent, at least in the Sixth Circuit.

ABC won the case, and kudos to its attorneys. Their decision to take the case to District Court rather than Tax Court made the case appealable to the Sixth Circuit, which venue made all the difference.