Self-Renting a Big Green Egg

Sometimes tax law requires you to witness the torture of the language. Other times it herds you through a sequence of “except for” clauses, almost assuring that some future Court will address which except is taking exception.

And then you have the laughers.

I came across an article titled: Corporation’s self-leasing rental expense deduction denied.”

I was curious. We tax nerds have an exceptionally low threshold for curiosity.

Before reading the article, I anticipated that:

(1)  Something was being deducted

(2)  That something was rent expense

(3)  Something was being self-leased, whatever that means, and

(4)  Whatever it means, the deduction was denied.

Let us spend a little time on (3).

Self-lease (or self-rental) means that you are renting something to yourself or, more likely, to an entity that you own. It took on greater tax significance in 1986 when Congress, frustrated for years with tax shelters, created the passive activity (PAL) rules. The idea was to separate business activities between actually working (active/material participation) and living the Kennedy (passive activity).

It is not a big deal if all the activities are profitable.

It can be a big deal if some of the activities are unprofitable.

Let’s go back to the classic tax shelter. A high-incomer wants to shelter high income with a deductible tax loss.

Our high-incomer buys a partnership interest in a horse farm or oil pipeline or Starbucks. The high-incomer does not work at the farm/pipeline/Starbucks, of course. He or she is an investor.

In the lingo, he/she is passive in the activity.

Contrast that with whatever activity generates the high income. Odds are that he/she works there. We would refer to that as active or material participation.

The 1986 tax act greatly restricted the ability of the high-incomer to use passive losses to offset active/material participation income.

Every now and then, however, standard tax planning is flipped on its head. There are cases where the high-incomer wants more passive income.

In the name of all that is holy, why?

Has to do with passive losses. Let’s say that you had $10,000 in passive losses in 2015. You could not use them to offset other income, so the $10,000 carried over to 2016. Then to 2017. They are gathering dust.

If we could create passive income, we could use those passive losses.

How to create passive income?

Well, let’s say that you own a company.

You rent something to the company.

Let’s rent your car, your office-in-home or your Big Green EGG XXL.

Rent is passive income, right? The tax on our passive income will be zero, as the losses will mop up every dollar of income.

That is the “self-rental” the tax Code is after.

But it also triggers one of those “except for” rules: if the self-rental results in income, the income will not qualify as passive income.

All your effort was for naught. Thank you for playing.

Back to the article I was reading.

There is a doctor. He is the only owner of a medical practice. He used the second story of his house solely for the medical practice. Fair be fair, he had the practice pay him rent for that second floor.

I have no problem with that.

The Tax Court disallowed the corporation a rent deduction.

Whaaat? That makes no sense.

The purpose of the passive/active/material participation rules is not to deny a deduction altogether. The purpose is to delay the use of losses until the right type of income comes around.

What was the Tax Court thinking?

Easy. The doctor never reported the rental income on his personal return.

This case has nothing to do with self-rental rules. The Court simply was not permitting the corporation a deduction for rent that its shareholder failed to report as income.

The case for the home gamers is Christopher C.L. Ng M.D. Inc.

When Do You Become A Landlord?

There is a requisite to being an NFL player – current or retired.

You must have played in the NFL.

There is a tax spiff on this point when you decide to landlord.

When does your rental start?

Probably when you place it in service, that is, when you have a tenant and begin receiving rent.

Can it start before then? Say that you are having trouble getting a tenant. Can you can say that you started renting before you have a tenant?

It probably can happen, but you had better line-up your facts in case of challenge.

I am looking at a case where the IRS assessed the following tax:

                 2004             $ 78,292

                     2005             $144,053     

                     2006             $218,228

                     2007             $143,729

                     2008             $252,777

                     2009             $309,060

Numbers like that will attract attention, the kind that can result in a challenge.

There is a doctor who now lives in Florida but used to live in Rhode Island. In 2004 he and his wife bought a mansion in Newport. The house was derelict, having been vacant for four decades.

It was uninhabitable, so the first thing they did was bring in a contractor.

It was a historic property, so there were also some tax credits in there.

Restoration started in 2002.

The work went into 2008.

That is a lot of restoration.

The family moved to Florida in 2005.

I suppose that answers the issue of whether this was ever a principal residence. It could not be if one could not live in it.

In 2006 they met a rental agent who specialized in luxury properties.

They got a temporary certificate of occupancy in 2007 and a final certificate in 2008.

Seems that one could argue that it was available for rent in 2007.

By 2007 the agent was hopeful she could attract a renter. She held up actively marketing it, however, as renovations were unfinished.

Sure enough, one of her clients expressed an interest in 2008.

The debt on this fiasco was ballooning, so the doctor and his wife decided to dump the house. The ante was upped when the bank increased their monthly payment in 2008 from $25 grand to $39 grand a month.

Count me out on ever renting this place.

In July, 2009 they sold the house.

They filed their 2009 tax return and reported a capital loss of a gazillion dollars.

Tax advisors are not overly fond of capital loses, as the only thing they can offset – with one exception – is capital gains. If you have no capital gains, then the loss just sits there – unused and gathering dust.

The doctor and his wife met a tax advisor who said that he could help: just treat the house as business property and the loss would be deductible. The good kind of loss – the kind you can actually lose.

They amended their 2009 return and reported a $8-plus million business loss.

Now they had a 2009 net operating loss. They carried the loss backward and forward. There were tax refunds and jollity aplenty.

However, numbers like that attract IRS attention, especially when you amend a return.

The IRS did not believe they had business property. If it was not business, then the initial reporting as capital loss was correct. The IRS wanted its money back.

Don’t think so, replied the doctor and his wife.

Off to Tax Court they went.

At issue was whether the house ever shifted to rental status, as that is the trigger for it to be business property.

There was one key – and punishing – fact: they never rented the house.

Here is the Court:

While we have no doubt that petitioners devoted a great deal of time, effort and expense to the renovation of Wrentham House Mansion, the record overwhelmingly confirms that Wrentham House Mansion was never held out for rent or rented after the restoration was complete. Quite simply, the rental activity with respect to Wrentham House Mansion never commenced in any meaningful or substantive way.”

Perhaps the doctor and his wife would have held on – at least long enough to rent for a while – if the monthly payment had not skyrocketed. They were pushed into a corner.

Still, no rent = no business = no business loss.

The best they could do was a capital loss.

What is the one exception to a capital loss I alluded to earlier?

You can deduct $3,000 a year against non-capital-gain property.

Which is no solace when you have an $8-plus million capital loss.

The case is Keefe v Commissioner for the homegamers.

Tax Mulligans and Tennessee Walking Horses

Here is the Court:

While a taxpayer is fee to organize [her] affairs as [she] chooses, nevertheless once having done so, [she] must accept the tax consequences of her choice, whether contemplated or not, and may not enjoy the benefit of some other route [she] might have chosen to follow but did not.”

This is the tax equivalent of “you made your bed, now lie in it.” The IRS reserves the right to challenge how you structure a transaction, but – once decided – you yourself are bound by your decision. 

Let’s talk about Stuller v Commissioner.  They were appealing a District Court decision.

The Stullers lived in Illinois, and they owned several Steak ‘n Shake franchises. Apparently they did relatively well, as they raised Tennessee walking horses. In 1985 they decided to move their horses to warmer climes, so they bought a farm in Tennessee. They entered into an agreement with a horse trainer addressing prize monies, breeding, ownership of foals and so on.

In 1992 they put the horse activity into an S corporation.

They soon needed a larger farm, so they purchased a house and 332 acres (again in Tennessee) for $800,000. They did not put the farm into the S corporation but rather kept it personally and charged the farm rent.

So far this is routine tax planning.

Between 1994 and 2005, the S corporation lost money, except for 1997 when it reported a $1,500 profit. All in all, the Stullers invested around $1.5 million to keep the horse activity afloat.

Let’s brush up on S corporations. The “classic” corporations – like McDonald’s and Pfizer – are “C” corporations. These entities pay tax on their profits, and when they pay what is left over (that is, pay dividends) their shareholders are taxed again.  The government loves C corporations. It is the tax gift that keeps giving and giving.

However C corporations have lost favor among entrepreneurs for the same reason the government loves them. Generally speaking, entrepreneurs are wagering their own money – at least at the start. They are generally of different temperament from the professional managers that run the Fortune 500. Entrepreneurs have increasingly favored S corporations over the C, as the S allows one level of income tax rather than two. In fact, while S corporations file a tax return, they themselves do not pay federal income tax (except in unusual circumstances).  The S corporation income is instead reported by the shareholders, who combine it with their own W-2s and other personal income and then pay tax on their individual tax returns.

Back to the Stullers.

They put in $1.5 million over the years and took a tax deduction for the same $1.5 million.

Somewhere in there this caught the IRS’ attention.

The IRS wanted to know if the farm was a real business or just somebody’s version of collecting coins or baseball cards. The IRS doesn’t care if you have a hobby, but it gets testy when you try to deduct your hobby. The IRS wants your hobby to be paid for with after-tax money.

So the IRS went after the Stullers, arguing that their horse activity was a hobby. An expensive hobby, granted, but still a hobby.

There is a decision grid of sorts that the courts use to determine whether an activity is a business or a hobby. We won’t get into the nitty gritty of it here, other than to point out a few examples:

·        Has the activity ever shown a profit?

·        Is the profit anywhere near the amount of losses from the activity?

·        Have you sought professional advice, especially when the activity starting losing buckets of money?

·        Do you have big bucks somewhere else that benefits from a tax deduction from this activity?

It appears the Stullers were rocking high income, so they probably could use the deduction. Any profit from the activity was negligible, especially considering the cumulative losses. The Court was not amused when they argued that land appreciation might bail-out the activity.

The Court decided the Stullers had a hobby, meaning NO deduction for those losses. This also meant there was a big check going to the IRS.

Do you remember the Tennessee farm?

The Stullers rented the farm to the S corporation. The S corporation would have deducted the rent. The Stullers would have reported rental income. It was a wash.

Until the hobby loss.

The Stullers switched gears and argued that they should not be required to report the rental income. It was not fair. They did not get a deduction for it, so to tax it would be to tax phantom income. The IRS cannot tax phantom income, right?

And with that we have looped back to the Court’s quote from National Alfalfa Dehydrating & Milling Co. at the beginning of this blog.

Uh, yes, the Stullers had to report the rental income.

Why? An S corporation is different from its shareholders. Its income might ultimately be taxed on an individual return, but it is considered a separate tax entity. It can select accounting periods, for example, and choose and change accounting methods. A shareholder cannot override those decisions on his/her personal return. Granted, 99 times out of 100 a shareholder’s return will change if the S corporation itself changes. This however was that one time.

Perhaps had they used a single-member LLC, which the tax Code disregards and considers the same as its member, there might have been a different answer.

But that is not what the Stullers did. They now have to live with the consequences of that decision.

When A Good Cause Is Not Enough

Let’s talk about the tax issues of tax-exempt entities. It sounds like a contradiction, doesn’t it?

It actually is its own area of practice. Several years ago I was elbow-deep working with nonprofits, and I attended a seminar presented by a specialist from Washington, D.C. All he did was nonprofits. At least he was in the right town for it.

There are the big-picture tax-exempt issues. For example, a 501(c)(3) has to be publicly-supported. You know there is a tractor-trailer load of rules as to what “publicly supported” means.

Then there are more specialized issues. One of them is the unrelated business income tax. The concept here is that a nonprofit cannot conduct an ongoing business and avoid tax because of its exemption. A museum may be a great charitable cause, for example, but one cannot avoid tax on a chain of chili restaurants by having the museum own them.

That is not what museums do. It is unrelated to “museum-ness,” and as such the chili restaurants will be taxed as unrelated business income.

Sometimes it can get tricky. Say that you have a culinary program at a community college. As part of the program, culinary students prepare meals, which are in turn sold on premises to the students, faculty and visitors. A very good argument can be made that this activity should not be taxed.  

What is the difference? In the community college’s case, the activity represents an expansion of the underlying (and exempt) culinary education program. The museum cannot make this argument with its chili restaurants.

However, what if the museum charges admission to view its collection of blue baby boots from Botswana? We are now closer to the example of culinary students preparing meals for sale. Exhibiting collections is what museums do.

I am looking a technical advice memorandum (TAM) on unrelated business income. This is internal IRS paperwork, and it means that an IRS high-level presented an issue to the National Office for review.

Let’s set it up.

There is a community college.

The community college has an alumni association. The association has one voting member, which is a political subdivision of the state.

The alumni association has a weekly farmers market, with arts and crafts and music and food vendors. It sounds like quite the event. It uses the parking areas of the community college, as well as campus rest rooms and utilities. Sometimes the college charges the alumni association; sometimes it does not.

The alumni association in turn rents parking lot space to vendors at the market.

All the money from the event goes to the college. Monies are used to fund scholarships and maintain facilities, such as purchasing a computer room for the library and maintaining the football field.

OBSERVATION: The tax Code does not care that any monies raised are to be used for a charitable purpose. The Code instead focuses on the activity itself. Get too close to a day-in-and-day-out business and you will be taxed as a business. Granted, you may get a charitable deduction for giving it away, but that is a different issue.

From surveys, the majority of visitors to the farmers market are age 55 and above.

There was an IRS audit. The revenue agent thought he spotted an unrelated business activity. The file moved up a notch or two at the IRS and a bigwig requested a TAM.

The association immediately conceded that the event was a trade or business regularly carried on. It had to: it was a highly-organized weekly activity.

The association argued instead that the event was its version of “museum-ness,” meaning the event furthered the association’s exempt purpose. It presented three arguments:

(1) The farmers market contributed to the exempt purpose of the college by drawing potential students and donors to campus, helping to develop civic support.

(2) The farmers market lessened the burden of government (that is, the college).

(3) The farmers market relieved the distress of the elderly.

The IRS saw these arguments differently:

(1) Can you provide any evidence to back that up? A mere assertion is neither persuasive nor dispositive.

COMMENT: The association should have taken active steps – year-after-year – to obtain and accumulate supporting data. It may have been worth hiring someone who does these things. Not doing so made it easy for the IRS to dismiss the argument as self-serving.

(2) At no time did the community college take on the responsibility for a farmers market, and the college is the closest thing to a government in this conversation. Granted, the college benefited from the proceeds, but that is not the test. The test is whether the association is (1) taking on a governmental burden and (2) actually lessening the burden on the government thereby.  As the government (that is, the college) never took on the burden, there can be no lessening of said burden.

COMMENT: This argument is interesting, as perhaps – with planning – something could have been arranged. For example, what if the college sponsored the weekly event, but contracted out event planning, organization and execution to the alumni association? 

(3) While the market did provide a venue for the elderly to gather and socialize, that is not the same as showing that the market was organized and worked with the intent of addressing the special needs of the elderly. 

COMMENT: Perhaps if the association had done things specifically for the elderly – transportation to/from retirement homes or free drink or meal tickets, for example – there would have been an argument. As it was, the high percentage of elderly was a happenstance and not a goal of the event.

There was no “museum-ness” there.

And then the association presented what I consider to be its best argument:

(4) We charged rent. Rent is specifically excluded as unrelated business income, unless special circumstances are present – which are not.

Generally speaking, rent is not taxable as unrelated business income unless there is debt on the property. The question is whether the payments the association received were rent or were something else.

What do I mean?

We would probably agree that leasing space at a strip mall is a textbook definition of rent. Let’s move the needle a bit. What would you call payment received for a hospital room? That doesn’t feel like rent, does it? What has changed? Your principal objective while in a hospital is medical attention; provision of the room is ancillary. The provision of space went from being the principal purpose of the transaction to being incidental.

The IRS saw the farmers’ market/arts and craft/et cetera as something more than a parking lot. The vendors were not so much interested in renting space as they were in participating (and profiting) from a well-organized destination and entertainment event. Landlords provide space. Landlords do not provide events. 

The IRS decided this was not rent.  

You ask why I thought this was the association’s best argument? Be fair, I did not say it was a winning argument, only that it was the best available.

The alumni association still has alternatives. Examination requested the TAM, so there will be no mercy there. That leaves Appeals and then possibly going to Court. A Court may view things differently.

And I am unhappy with the alumni association. I suspect that the farmers’ market went from humble origins to a well-organized, varied and profitable event. As a practitioner, however, I have to question whether they ever sought professional advice when this thing started generating pallet-loads of cash. Granted, the activity may have evolved to the point that no tax planning could save it, but we do not know that. What we do know is that little – if any – planning occurred. 

Deducting Something, On Some Lake, Somewhere

Someone asked me during the busy season how I came up with the topics for this tax blog. 

It is whatever catches the eye of a somewhat-ADD 30-year tax CPA.  We are a bit of a garage tax blog, I guess.

What caught my eye this week was another case concerning rental property. It gives us a chance to talk about the “vacation home” rules. If you have a second home, odds are good that you and your tax preparer have talked about these rules.

Let’s say that a person – let’s call him Steve – buys a second home. It is in Tennessee. Steve likes Tennessee.

There are three things that Steve can do with his home in Tennessee:

(1) It can be a true second home. Steve, Mrs. Steve and Steve-descendants use it whenever they can. No non-Steves use the home.

(2)  It can be rented. Steve never uses it, as it is being rented to non-Steves.

(3)  Steve uses it some and rents it some.

It is (3) that drags us into the vacation home rules.

Let’s recall what the tax difference is between owning a house as a primary residence and owning it as a rental:

(1) Primary residence – you can deduct…

a.     Mortgage interest

b.     Real estate taxes

(2) Rental – you can deduct…

a.     Mortgage interest

b.     Real estate taxes

c.      Operating costs, such as utilities and insurance

d.     Maintenance costs, such as mowing in the summer and snow removal in the winter

e.     Depreciation

As you can see, there is a wider range of potential tax deductions if only we can qualify Tennessee as a rental.

Congress and the IRS know this. That is how we got the vacation home rules to begin with. You cannot rent out the place one week out of year, use it personally the rest of the time and deduct everything that is not tied down.

Our Code section is 280A and it is a math quiz:

(1) Did you rent the place for less than 15 days during the year?

(2) If no …

a.     Did you use it personally less than 10% of the days it was rented out?

Let’s go through it.

 

(1) If you rent the place for two weeks or less, the rental income is not taxable. Mortgage interest and real estate taxes are deductible the same as a residence.

COMMENT: Makes no sense, right? The IRS is actually letting you NOT REPORT income? How did that get in there? I bet it has something to do with Augusta and the Masters. It helps to know people who know people. 

(2) You rent it out more than two weeks and use it more than 10% of the rental days.

Congratulations, you have a second home. You also have rental income. You have to report the rental income, but the IRS is kind enough to allow you to take rental deductions UP TO A POINT. You cannot claim so many deductions that you reach the point of a tax loss. You must stop at zero

The deductions get allocated between the personal use days and the rental use days. It’s only fair.

Since it is a second home, you get to deduct whatever interest and taxes were not allocated to the rental as personal mortgage interest and personal real estate taxes.

(3) You rent it out more than two weeks and use it less than 10% of the rental days.

You still have to allocate the expenses as we discussed in (2), but the IRS now allows you to claim a rental loss. Why? Because at less than 10% personal use the IRS does NOT consider this to be your second home. The IRS considers it a rental.

There is a downside, though. You know that mortgage interest allocated to the personal use? It is not deductible anymore. Why? Because the only thing that made it deductible before was that it was attached to your second home.  As we said, under scenario (3) the IRS considers this to be a rental, meaning it is not your second home.

You do get to deduct the real estate taxes allocated to the personal use.  Taxes have a different tax treatment.

There are some special rules on counting days. For example, days spent repairing or maintaining the property do not count, either as personal use or as rental. You might want to document these days well, though.

What if Steve wants to allow Steve-descendants to use the place?

Most of the time this will not work. The reason is that Steve-descendants are considered to be Steve, and that means personal use days.

But there is small exception…

Steve-descendants will not be considered to be Steve if:

·     They pay fair market rent, and

·     They use the place as their principal residence

It is the second requirement that causes the problem. Put the house in Hilton Head or Key West and odds are that no one is using the place as a principal residence.

However, put a Steve-descendant into medical school in Tennessee and you may have the beginnings of a tax plan.

Our case this week is Cheryl Savello v Commissioner. She had more than one thing going, but our interest is whether she got to treat a Nevada property where her daughters stayed as rental property.

Her daughters used the place as their principal residence.

The Court agreed that the rent appeared to be market value, citing offers to rent from third parties.

But the Court decided that there was no rental. The daughters’ use was attributable to their mother.

What happened?

Her daughters didn’t pay the rent.