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Showing posts with label rent. Show all posts
Showing posts with label rent. Show all posts

Monday, August 28, 2023

The Augusta Rule And Renting To Yourself


I came across the Augusta rule recently.

This is Code section 280A(g), the tax provision that allows one to rent their home for less than 15 days per year without paying tax on the income. It got its name from the famous Augusta National Golf Club in Georgia. There would not be sufficient housing during the Masters without participation by local homeowners. The section has been with us since the 1970s.

There are requirements, of course:

(1)  The property must be in the U.S.

(2)  The property needs to be a residence. Mind you, it does not need to be your primary residence. It can be a second home. Or a third home, if you are so fortunate.

(3)  The house cannot be a place of business.

a.    The Augusta rule does not work well with an office-in-home, for example.

(4)  Rental expenses (excluding expenses such as mortgage interest and taxes which are deductible irrespective of any rental) become nondeductible.

(5)  A proprietorship (or disregarded single-member LLC) does not qualify. Mind you, a corporation you wholly own will qualify, but your proprietorship will not.

a.    Another way to say this is that both the rental income and expense cannot show up on the same tax return.

(6)  The rent must be reasonable.

(7)  There must be a business purpose for the rental.

Tax advisors long ago realized that they could leverage the Augusta rule if the homeowner also owned a business. How? Have the business rent the house from the homeowner for less than 15 days over a rolling 12-month period.

Can it work?

Sure.

Will the IRS challenge it?

Let’s look at a recent case to see a common IRS challenge to Augusta-rule rentals.

Two anesthesiologists and an orthopedic representative owned Planet LA, LLC (Planet). Planet in turn owned several Planet Fitness franchises in Louisiana. It opened its first one in 2013 and was up to five by 2017 when it sold all its franchises.

The three shareholders had issues with regular business meetings because of work schedules and distance. Beginning in 2015 they decided to have regular meetings at their residences. Planet would pay rent (of course), which varied in amount until it eventually settled on $3,000 per month to each shareholder.

One of the advantages of having three shareholders was being able to apply the Augusta rule to three houses. If you think about it, this allowed Planet to have up to 42 meetings annually without voiding the day count for any one residence.

Let’s do some quick math.

$3,000 x 3 shareholders x 14 meetings = $126,000

Planet could deduct up to $126,000 and the shareholders would report no rental income.

Sweet.

The IRS wanted to look at this.

Of course.

The first IRS challenge: show us agendas and notes for each meeting.

Here is the Court:

Petitioners failed to produce any credible evidence of what business was conducted at such meetings, and their testimony was vague and unconvincing regarding the meetings.”

Oh, oh.

The second challenge: the revenue agent researched local rental rates for meeting space. He determined that one could rent space accommodating up to 1,200 people for $500 per day.

The shareholders could not prove otherwise.

Here is the Court:

While petitioners argue that the $500 rent determined by … was not reasonable, we disagree and find to the contrary that $500 allowed per month is actually generous.”

This was almost too easy for the IRS.

·      Prove the number of meetings.

·      Multiply that number by $500.

The IRS allowed Planet rent deductions as follows:

          2017           none, as no meetings were proven

          2018           12 meetings times $500 = $6,000

          2019           9 meetings times $500 = $4,500

The shareholders had deducted $290,900 over three years.

The IRS allowed $10,500.

Yep, that is an IRS adjustment of over $280 grand over three years, with minimal effort by the IRS.

And that is how the IRS goes after the Augusta rule in a self-rental context.

The takeaway?

The Augusta rule can work, but you want to document and substantiate everything.

You want to have agendas for every meeting, perhaps followed up with minutes of the same.

Be careful (and reasonable) with the rental rate. This is not VRBO. You are renting a portion of a house, not the full house. You are renting for a portion of a day, not for days or weeks. You cannot just look up weekly house rentals online and divide them by seven. Those rental rates are for a different use and not necessarily comparable to business use of the residence.

You may want to formally invoice the business.

You want to pay the rent from the business bank account.

Our case this time was Sinopoli et al v Commissioner, T.C. Memo 2023-105.

Sunday, March 26, 2023

Renting a Home Office To An Employer

A client asked about the home office deduction last week.

This deduction has lost much of its punch with the Tax Cuts and Jobs Act of 2017. The reason is that employee home office deductions are a miscellaneous itemized deduction, and most miscellaneous itemized deductions have been banned for the next two-plus years. 

The deduction still exists for self-employeds, however, including partners in a partnership or members in an LLC. Technically there is one more hoop for partners and members, but let’s skip that for now.

Say you are working from home. You have a home office, and it seems to pass all the bells-and-whistles required for a tax deduction. Can you deduct it?

Depends. On what? On how you are compensated.

(1) If you are a W-2 employee, then you have no deduction.

(2) If you receive a 1099 (think gig worker), then you have a deduction.

Seems unfair.

Can we shift those deductions to the W-2 employer? Would charging rent be enough to transform the issue from being an employee to being a landlord?

There was a Tax Court case back in the 1980s involving the tax director of a public accounting firm in Phoenix (Feldman). His position involved considerable administrative work, a responsibility difficult to square with being accessible to staff at work while also maintaining confidentiality on private firm matters.

Feldman built a house, including a dedicated office.  He worked out an above-market lease with his firm. He then deducted an allocable share of everything he could against that rent, including maid service.

No surprise, Feldman and the IRS went to Tax Court.

Let’s look at the Code section under dispute:

Sec 280A Disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc.

(a)  General rule.

Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.

Thanks for the warm-up, said Feldman., but let’s continue reading:

      Sec 280A(c)(3) Rental use.

Subsection (a) shall not apply to any item which is attributable to the rental of the dwelling unit or portion thereof (determined after the application of subsection (e).

I am renting space to the firm, he argued. Why are we even debating this?

The lease is bogus, said the IRS (the “respondent”).

Respondent does not deny that under section 280A a taxpayer may offset income attributable to the rental of a portion of his home with the costs of producing that rental income. He contends, however, that the rental arrangement here is an artifice arranged to disguise compensation as rental income in order to enable petitioner to avoid the strict requirements of section 280A(c)(1) for deducting home office expenses. Because there was no actual rental of a portion of the home, argues respondent, petitioner must qualify under section 280A(c)(1) before he may deduct the home office expenses.

Notice that the IRS conceded that Feldman was reading the Code correctly. They instead were arguing that he was violating the spirit of the law, and they insisted the Court should observe the spirit and not the text.

The IRS was concerned that the above-market rent was disguised compensation (which it was BTW). Much of tax practice is follow-the-leader, so green-lighting this arrangement could encourage other employers and employees to shift a portion of their salaries to rent. This would in turn free-up additional tax deductions to the employee - at no additional cost to the employer but at a cost to the fisc.

The IRS had a point. As a tax practitioner, I would use this technique - once blessed by the Court – whenever I could.

The Court adjusted for certain issues – such as the excess rent – but decided the case mostly in Feldman’s favor.

The win for practitioners was short-lived. In response Congress added the following to the Code:

      (6)  Treatment of rental to employer.

Paragraphs (1) and (3) shall not apply to any item which is attributable to the rental of the dwelling unit (or any portion thereof) by the taxpayer to his employer during any period in which the taxpayer uses the dwelling unit (or portion) in performing services as an employee of the employer.

An employer can pay rent for an employee’s office in home, said Congress, but we are disallowing deductions against that rental income.

Our case this time was Feldman v Commissioner, 84 T.C. 1 (U.S.T.C. 1985).

 

Sunday, January 9, 2022

Starting A Business In The Desert

 

Tax has something called “startup costs.”

The idea is to slow down how quickly you can deduct these costs, and it can hurt.

Let’s take a common enough example: starting a restaurant.

You are interested in owning a restaurant. You look at several existing restaurants that may be available for purchase, but you eventually decide to renovate existing space and open your own- and new – restaurant. You lease or buy, then hire an architect for the design and a contractor for the build-out of the space.

You are burning through money.

You still do not have a tax deduction. Expenses incurred when you were evaluating existing restaurants are considered investigatory expenses. The idea here is that you were thinking of doing something, but you were not certain which something to do – or whether to do anything at all.

Investigatory expenses are a type of startup expense.

The contractor comes in. You are installing walls and windows and floors and fixtures. The equipment and furniture are delivered next.

You will depreciate these expenses, but not yet. Depreciation begins when an asset is placed in service, and it is hard to argue that assets are placed in service before the business itself begins.

You still do not have a tax deduction.

You will be the head chef, but still need your sous and line chefs, as well as a hostess, waitpersons, bartender and busboys. You have payroll and you have not served your first customer.

It is relatively common for a restaurant to have a soft launch, meaning the restaurant is open to invited guests only. This is a chance to present the menu and to shakedown the kitchen and floor staff before opening doors to the general public. It serves a couple of purposes: first, to make sure everyone and everything is ready; second, to stop the startup period. 

Think about the expenses you have incurred just to get to your soft launch: the investigatory expenses, the architect and contractor, the construction costs, the fixtures and furniture, employee training, advertising and so on.

Carve out the stuff that is depreciable, as that has its own rules. The costs that are left represent startup costs.

The tax Code – in its wisdom or jest – allows you to immediately deduct up to $5,000 of startup costs, and even that skeletal amount is reduced if you have “too many” startup costs.

Whatever remains is deductible pro-rata over 15 years.

Yes, 15 years. Almost enough time to get a kid through grade and high school.

You clearly want to minimize startup costs, if at all possible. There are two general ways to do this:

·      Start doing business as soon as possible.  Perhaps you start takeout or delivery as soon as the kitchen is ready and before the overall restaurant is open for service.

·      You expand an existing business, with expansion in this example meaning your second (or later) restaurant. While you are starting another restaurant, you are already in the business of operating restaurants. You are past startup, at least as far as restaurants go.

Let’s look at the Safaryan case.

In 2012 or 2013 Vardan Antonyan purchased 10 acres in the middle of the Mojave desert. It was a mile away from a road and about 120 miles away from where Antonyan and his wife lived. It was his plan to provide road access to the property, obtain approval for organic farming, install an irrigation system and subdivide and rent individual parcels to farmers.  

The place was going to be called “Paradise Acres.” I am not making this up.

Antonyan created a business plan. Step one was to construct a nonlivable structure (think a barn), to be followed by certification with the Department of Agriculture, an irrigation system and construction of an access road.

Forward to 2015 and Antoyan was buying building materials, hiring day laborers and renting equipment to build that barn.

Antoyan and his wife (Safaryan) filed their 2015 tax return and claim approximately $25 thousand in losses from this activity.

The IRS bounced the return.

Their argument?

The business never started.

How did the IRS get there?

Antonyan never accomplished one thing in his business plan by the end of 2015. Mind you, he started constructing the barn, but he had not finished it by year-end. This did not mean that he was not racking-up expenses. It just meant that the expenses were startup costs, to be deducted at that generous $5,00/15-year burn rate starting in the year the business actually started.

The Court wanted to see revenue. Revenue is the gold standard when arguing business startup. There was none, however, placing tremendous pressure on Antonyan to explain how the business had started without tenants or rent – when tenants and rent were the entirety of the business.  Perhaps he could present statements from potential tenants about negotiations with Antonyan – something to persuade the Court.   

He couldn’t.

Meaning he did not start in 2015.

Our case this time was Safaryan v Commissioner, T.C. Memo 2021-138.

Sunday, May 9, 2021

IRS Challenges Rent In A Small Town


Let’s look at a case involving rent.

What sets this up is a C corporation in Montana.

A C corporation means that it pays its own tax. Contrast this with an S corporation, which (with rare exception) passes-through its income to its shareholders, who then combine that income with their own income (W-2, interest and dividends) and pay tax personally.

As a generalization, a tax advisor working with entrepreneurial clients is much more likely to work with S corporations (or LLCs, an increasingly popular choice). The reason is simple: a C corporation has two levels of tax: once to the company itself and then to the owners when distributed as dividends. Now that may not be an issue to a Fortune 1000, some of which are larger than certain countries and themselves are near-permanent entities - expected to outlive any current corporate officer or investor. It however is an issue to a closely-held company that will be lucky to transition one generation and unlikely to transition two.

Plentywood Drug is a Montana corporation that operates the only pharmacy in Plentywood, Montana and serves four counties spanning 7,200 square miles.

The company has four owners, representing two families.

It leases a building owned by its four owners.

COMMENT: So far, there is zero unusual about this.

The company paid the following rent:

           2011                       $ 83,584

           2012                       $192,000

           2013                       $192,000

The IRS did not like this one bit.

Why not?

Let’s go tax nerd for a moment. The IRS said that the company was paying too much in rent. Rent is deductible. Excess rent is considered a dividend and is not deductible. The corporation would lose a deduction for its excess rent. The owners however received $192,000, so they are going to be taxed on that amount. How will they be taxed if the IRS ratches-down the rent? The excess will be considered dividends and taxed to them accordingly.

Remember: a C corporation does not get a deduction for dividends. The IRS gets more tax from the company while the individual taxes of the four owners stays the same. It’s a win for the IRS.

An S corporation does not have this issue, as all income of the S is taxed to its owners. This is another reason that tax advisors representing entrepreneurial wealth prefer working with S corporations.

How does the IRS win this?

Well, it has to show that $192,000 is too much rent.

Problem: the town of Plentywood has 1,700 people.

Another problem: Montana is a nondisclosure state, meaning real estate data – such as sales prices – is legally confidential and simply not available.

The IRS brought in its valuation specialist. Third problem: Montanans do not tend to share financial information easily with strangers.

The IRS expert remarked that that he did not identify himself as an IRS agent while he was in Plentywood.

Probably for the best.

Then the IRS expert made a fateful decision: he would base his appraisal solely on Plentywood data.

Well, that should take about half a day.

He looked at the post office, two apartment buildings and a 625-square-foot commercial space.

He did the best he could to compensate by making adjustments: for commercial versus residential, for the safety of the Post Office as a tenant, for Aaron Rodgers possibly leaving the Packers.

The two families brought in their specialist, who supplemented his database by including Williston, North Dakota – the “big town” about an hour away and with a population about eight times the size.

The IRS argued that Williston was simply not comparable.

Here is the Court:

We therefore do not accept the Williston properties as being reasonable comparisons.”

Oh oh.

The two families argued that the IRS specialist was mixing tamarinds and eggplants.

Here is the Court:

His expert used two residential properties in his analysis. Government-subsidized multifamily residential housing is like a retail drugstore in that both are rented. But not in much else.”

You can tell the Court was frustrated.

How about the post office? Both sides used the post office.

Yet even though both sides agree that the post office is comparable, they disagree about the number of square feet it has.”

The Court – having to do something – decided that fair rent was $171,187.

The IRS then wanted penalties. The IRS always wants penalties.

What for?

The Commissioner alleges that the first cause on this list – negligence or disregard of rules or regulations … - applies to Plentywood Drug ….”

The Court squinted and said: What? You brought a trial, the rent turned out to be within $20 grand of what the families deducted in the first place, we have heard far too much about appraising properties over frontier America and you have the nerve to say that there was negligence or disregard?

The Court adjusted the rent and nixed the penalties.

Our case this time was Plentywood Drug Inc v Commissioner, T.C. Memo 2021-45.

Sunday, August 9, 2020

Don’t Be A Jerk

 

I am looking at a case containing one of my favorite slams so far this year.

Granted, it is 2020 COVID, so the bar is lower than usual.

The case caught my attention as it begins with the following:

The Johnsons brought this suit seeking refunds of $373,316, $192,299, and $114,500 ….”

Why, yes, I would want a refund too.

What is steering this boat?

… the IRS determined that the Johnsons were liable for claimed Schedule E losses related to real estate and to Dr. Johnson’s business investments.”

Got it. The first side of Schedule E is for rental real estate, so I gather the doctor is landlording. The second side reports Schedules K-1 from passthroughs, so the doctor must be invested in a business or two.

There is a certain predictability that comes from reviewing tax cases over the years. We have rental real estate and a doctor.

COMMENT: Me guesses that we have a case involving real estate professional status. Why? Because you can claim losses without the passive activity restrictions if you are a real estate pro.

It is almost impossible to win a real estate professional case if you have a full-time gig outside of real estate.  Why? Because the test involves a couple of hurdles:

·      You have to spend at least 750 hours during the year in real estate activities, and

·      Those hours have to be more than ½ of hours in all activities.

One might make that first one, but one is almost certain to fail the second test if one has a full-time non-real-estate gig. Here we have a doctor, so I am thinking ….

Wait. It is Mrs. Johnson who is claiming real estate professional status.

That might work. Her status would impute to him, being married and all.

What real estate do they own?

They have properties near Big Bear, California.

These were not rented out. Scratch those.

There was another one near Big Bear, but they used a property management company to help manage it. One year they used the property personally.

Problem: how much is there to do if you hired a property management company? You are unlikely to rack-up a lot of hours, assuming that you are even actively involved to begin with.

Then there were properties near Las Vegas, but those also had management companies. For some reason these properties had minimal paperwork trails.

Toss up these softballs and the IRS will likely grind you into the dirt. They will scrutinize your time logs for any and every. Guess what, they found some discrepancies. For example, Mrs. Johnson had counted over 80 hours studying for the real estate exam.

Can’t do that. Those hours might be real-estate related, but the they are not considered operational hours - getting your hands dirty in the garage, so to speak. That hurt. Toss out 80-something hours and …. well, let’s just say she failed the 750-hour test.

No real estate professional status for her.

So much for those losses.

Let’s flip to the second side of the Schedule E, the one where the doctor reported Schedules K-1.

There can be all kinds of tax issues on the second side. The IRS will probably want to see the K-1s. The IRS might next inquire whether you are actually working in the business or just an investor – the distinction means something if there are losses. If there are losses, the IRS might also want to review whether you have enough money tied-up – that is, “basis” - to claim the loss. If you have had losses over several years, they may want to see a calculation whether any of that “basis” remains to absorb the current year loss.

 Let’s start easy, OK? Let’s see the K-1s.

The Johnson’s pointed to a 1000-plus page Freedom of Information request.

Here is the Court:

The Johnsons never provide specific citations to any information within this voluminous exhibit and instead invite the court to peruse it in its entirety to substantiate their arguments.”

Whoa there, guys! Just provide the K-1s. We are not here to make enemies.

Here is the Court:

It behooves litigants, particularly in a case with a record of this magnitude, to resist the temptation to treat judges as if they were pigs sniffing for truffles.”

That was a top-of-the-ropes body slam and one of the best lines of 2020.

The Johnsons lost across the board.

Is there a moral to this story?

Yes. Don’t be a jerk.

Our case this time was Johnson DC-Nevada, No 2:19-CV-674.

Sunday, May 10, 2020

Deducting Expenses Paid With Paycheck Protection Loans


There was a case in 1931 that is influencing a public controversy today.

Let’s talk about it.

The taxpayer (Slayton) was in the business of buying, holding and selling tax-exempt bonds. He would at times borrow money to buy or to carry tax-exempt bonds he already owned.

Slayton had tax-exempt interest income coming in. That amount was approximately $65 thousand.

Slayton was also paying interest. That amount was approximately $78 thousand.
COMMENT: On first read it does not appear that dear old Slayton was the Warren Buffett of his day.
Time came to file his tax return. He omitted the $65 grand in interest received because … well, it was tax-exempt.

He deducted the $78 grand that he was paying to carry those tax-exempt securities.

The IRS said no dice.

Off to Court they went.

Slayton was hot. He made several arguments:

(1)  The government was discriminating against owners of tax-exempt securities and – in effect – nullifying their exemption from taxation.
(2)  The government was discriminating against dealers in tax-exempt bonds that had to borrow money to carry an inventory of such bonds.
(3)  The government was discriminating in favor of dealers of tax-exempt bonds who did not have to borrow to carry an inventory of such bonds.

I admit: he had a point.

The government had a point too.

(1)  The income remained tax-exempt. The issue at hand was not the interest income; rather it was the interest expense.
(2)  Slayton borrowed money for the express purpose of carrying tax-exempt securities. This was not an instance where someone owned an insubstantial amount of tax-exempts within a larger portfolio or where a business owning tax-exempts borrowed money to meet normal business needs.

The link between the bonds and the loans to buy them was too strong in this case. The Court disallowed the interest expense. Since then, tax practitioners refer to the Slayton issue as the “double-dip.”  The dip even has its own Code section:
        § 265 Expenses and interest relating to tax-exempt income.
(a)  General rule.
No deduction shall be allowed for-
(1)  Expenses.
Any amount otherwise allowable as a deduction which is allocable to one or more classes of income other than interest (whether or not any amount of income of that class or classes is received or accrued) wholly exempt from the taxes imposed by this subtitle, or any amount otherwise allowable under section 212 (relating to expenses for production of income) which is allocable to interest (whether or not any amount of such interest is received or accrued) wholly exempt from the taxes imposed by this subtitle.

Over the years the dip has evolved to include income other than tax-exempt interest, but the core concept remains: one cannot deduct expenses with too strong a tie to nontaxable income.

Let’s fast forward almost 90 years and IRS Notice 2020-32.

To the extent that section 1106(i) of the CARES Act operates to exclude from gross income the amount of a covered loan forgiven under section 1106(b) of the CARES Act, the application of section 1106(i) results in a “class of exempt income” under §1.265- 1(b)(1) of the Regulations. Accordingly, section 265(a)(1) of the Code disallows any otherwise allowable deduction under any provision of the Code, including sections 162 and 163, for the amount of any payment of an eligible section 1106 expense to the extent of the resulting covered loan forgiveness (up to the aggregate amount forgiven) because such payment is allocable to tax-exempt income. Consistent with the purpose of section 265, this treatment prevents a double tax benefit.

I admit, it is not friendly reading.

The CARES Act is a reference to the Paycheck Protection loans. These are SBA loans created in response to COVID-19 to help businesses pay salaries and rent. If the business uses the monies for their intended purpose, the government will forgive the loan.

Generally speaking, forgiveness of a loan results in taxable income, with exceptions for extreme cases such as bankruptcy. The tax reasoning is that one is “wealthier” than before, and the government can tax that accession to wealth as income.

However, the CARES Act specifically stated that forgiveness of a Paycheck Protection loan would not result in taxable income.

So we have:

(1)  A loan that should be taxable – but isn’t - when it is forgiven.
(2)  A loan whose proceeds are used to pay salaries and rent, which are routine deductible expenses.

This sets up the question:

Are the salaries, rent and other qualified expenses paid with a Paycheck Protection loan deductible?

You see how we got to this question, with Section 265, Slayton and subsequent cases that expanded on the double dip.

The IRS said No.

This answer makes sense from a tax perspective.

This answer does not make sense from a political perspective, with Senators Wyden and Grassley and Representative Neal writing to Secretary Mnuchin that this result was not the intent of Congress.

I believe them.

I have a suggestion.

Change the tax law.



Sunday, April 21, 2019

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 (75th Place) in 1997.

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

Renovations to 75th Place were completed in 2010.

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

Sunday, July 1, 2018

TurboTax and Penalties


I am looking at a case that deals with recourse and nonrecourse debt.

Normally I expect to find a partnership with multiple pages of related entities and near-impenetrable transactions leading up to the tax dispute.

This case had to do with a rental house. I decided to read through it.

Let’s say you buy a house in northern Kentucky. You will have a “recourse” mortgage. This means that – if you default – the mortgage company has the right to come after you for any shortfall if sales proceeds are insufficient to pay-off the mortgage.

This creates an interesting tax scenario in the event of foreclosure, as the tax Code sees two separate transactions.

EXAMPLE:

          The house cost               $290,000
          The mortgage is             $270,000
          The house is worth        $215,000

If the loan is recourse, the tax Code first sees the foreclosure:

          The house is worth        $215,000
          The house cost               (290,000)
          Loss on foreclosure       ($75,000)

The Code next sees the cancellation of debt:

          The mortgage is worth  $270,000
          The house is worth        (215,000)
          Cancellation of debt       $55,000

If the house is your principal residence, the loss on foreclosure is not tax deductible. The cancellation-of-debt income is taxable, however.

But all is not lost. Here is the Code:
§ 108 Income from discharge of indebtedness.
(a)  Exclusion from gross income.
(1)  In general.
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if-
(E)  the indebtedness discharged is qualified principal residence indebtedness which is discharged-
(i)  before January 1, 2018, or
(ii)  subject to an arrangement that is entered into and evidenced in writing before January 1, 2018.

The Section 108(a)(1)(E) exclusion will save you from the $55,000 cancellation-of-debt income, if you got it done by or before the December 31, 2017 deadline.

Let’s change the state. Say that you bought your house in California.

That loan is now nonrecourse. That lender cannot hound you the way he/she could in Kentucky.

The taxation upon cancellation of a nonrecourse loan is also different. Rather than two steps, the tax Code now sees one.

Using the same example as above, we have:

          The mortgage is             $270,000
          The house cost               (290,000)
          Loss on foreclosure       ($20,000)  

Notice that the California calculation does not generate cancellation-of-debt income. As before, the loss is not deductible if it is from your principal residence.

Back to the case.

A married couple had lived in northern California and bought a residence. They moved to southern California and converted the residence to a rental. The housing crisis had begun, and the house was not worth what they had paid.

Facing a loss of over $300 grand, they got Wells Fargo to agree to a short sale. Wells Fargo then sent them a 1099-S for taking back the house and a 1099-C for cancellation-of-debt income.

Seems to me Wells Fargo sent paperwork for a sale in Kentucky. Remember: there can be no cancellation-of-debt income in California.

The taxpayer’s spouse prepared the return. She was an attorney, but she had no background in tax. She spent time on TurboTax; she spent time reading form instructions and other sources. She did her best. You know she was reviewing that recourse versus nonrecourse thing, as well as researching the effect of a rental. She may have researched whether the short sale had the same result as a regular foreclosure.
COMMENT: There was enough here to use a tax professional.
They filed a return showing around $7,000 in tax.

The IRS scoffed, saying the correct tax was closer to $76,000.

There was a lot going on here tax-wise. It wasn’t just the recourse versus nonrecourse thing; it was also resetting the “basis” in the house when it became a rental.

There is a requirement in tax law that property convert at lower of (adjusted) cost or fair market value when it changes use, such as changing from a principal residence to a rental. It can create a no-man’s land where you do not have enough for a gain, but you simultaneously have too much for a loss. It is nonintuitive if you haven’t been exposed to the concept.

Here is the Court:
This is the kind of conundrum only tax lawyers love. And it is not one we've been able to find anywhere in any case that involves a short sale of a house or any other asset for that matter. The closest analogy we can find is to what happens to bases in property that one person gives to another.”
Great. She had not even taken a tax class in law school, and now she was involved with making tax law.

Let’s fast forward. The IRS won. They next wanted penalties – about $14,000.

The Court didn’t think penalties were appropriate.
… the tax issues they faced in preparing their return for 2011 were complex and lacked clear answers—so much so that we ourselves had to reason by analogy to the taxation of sales of gifts and consider the puzzle of a single asset with two bases to reach the conclusion we did. We will not penalize taxpayers for mistakes of law in a complicated subject area that lacks clear guidance …”
They owed about $70 grand in tax but at least they did not owe penalties.

And the case will be remembered for being a twist on the TurboTax defense. Generally speaking, relying on tax software will not save you from penalties, although there have been a few exceptions. This case is one of those exceptions, although I question its usefulness as a defense. The taxpayers here strode into the tax twilight zone, and the Court decided the case by reasoning through analogy. How often will that fact pattern repeat, allowing one to use this case against the imposition of future penalties?

The case for the homegamers is Simonsen v Commissioner 150 T.C. No. 8.