Converting A Residence To A Rental

I have a client who owns a very nice house. Too nice, in fact, at least for its neighborhood. My client used to have a contracting business, and he used his business talents and resources to improve his residence. He is now thinking of moving to another city, and it is almost assured he will lose money when he sells his house.

He is quite creative in thinking of ways to make that loss tax deductible.

The first thought is to convert it to a rental. One can deduct losses on the sale of a rental, right?

There are two significant issues with this plan. One has to do with the amount of loss one can deduct when the rental is underwater – that is, when it costs more than it is worth. The second has to do with whether there actually is rental activity.

We have previously talked about the second point, especially when one rents to family. Doing so is not fatal, but doing so on the cheap (not charging rent or enough rent) is.

Consider the following:

The Langstons purchased a residence (75^th Place) in 1997.

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

Renovations to 75^th Place were completed in 2010.

In 2011 they received an unwanted telephone call from their insurance agent. Someone had to live at 75^th Place or the insurance would be terminated.

In July, 2011 Mr. Langston rented the property to a fraternity brother for $500 a month.

COMMENT: The market rent was between $2,500 and $2,800 a month, but the fraternity brother would be home about five days per month. Mr. Langston prorated the rent accordingly.

In 2013 they finally sold 75^th Place. They deducted a loss of over $400 grand.

QUESTION: Do you think they successfully converted the property to a rental?

Let’s consider a few factors.

·      What was their intent when they moved to an apartment?

If the intent was to renovate and sell, this would indicate an income-producing purpose. The problem is that the renovations went on forever.

·      They tried to rent the property

No, actually they did not. In fact, the Court thought that they rented the property only after the insurance company threatened to cut-off their insurance.

·      They actually rented the property

For much less than market value rent. The Court was not impressed by that.

·      They tried to sell the property

Eventually, after nearly a decade and after never marketing the property. They did not even seek an appraisal until a refinancing required them to do so.

The Court decided that they never converted the property to a rental. There was no deductible loss.

Zero surprise. I get the feeling that the taxpayers did whatever they wanted for however long, and near the end they wanted some tax leverage from the deal. It was a bit unfair to the tax practitioner, as some planning – any planning – might have helped.

Let’s go crazy with their planning. What can we do….? Let me think, let  me… I got it! How about actually renting the place before the insurance company is about to drop you? How about charging market rent – or at least close?  How about listing the house with a realtor? Shheeesssh.

I suspect my client is shrewder than the Langstons. He however cannot get past the second tax issue.

You see, when you have a personal asset (say your residence) which you convert to income-producing status (say a rental), you have to look at its basis and its fair market value when you convert.

Basis is a fancy word for what you paid to acquire or improve the asset. Say that my client has $1.5 million in his house.

Say he converts May 1^st, when the house is worth $1 million.

He now has a “dual basis” situation.

His basis for calculating gain is $1.5 million.

But his basis for calculating loss is $1 million.

You see what happened? He was hoping to use that $1.5 million to calculate any loss on sale. Folks, the IRS figured out this gimmick ages ago. That is how we wound up with the dual basis rule.

I suspect the Langstons had a similar situation, but they never got to first base. You see, their activity had to qualify first as a rental before the Court would have to consider the dual basis rule. The activity didn’t, so the Court didn’t.

Our case this time was Carlos and Pamela Langston, TC Memo 2019-19.

You Inherit. Can You Owe Estate Tax?

I came across an estate tax lien case the other day.

It has become unlikely that one will owe estate tax, as the lifetime exclusion has now gone over $11 million. Still, it can and does happen.

The federal estate tax is an odd beast. It is a combination of assets owned or controlled at death, increased by an addback for reportable lifetime gifts. This system is called a “unified” tax, and the intent is to not avoid the estate tax by giving property away to family over the course of a lifetime. In truth, the addback is necessary, as tax planners (including me) would drive an 18-wheeler through the estate tax if the lifetime-gift addback did not exist.

There is a potential trap if the estate tax kicks-in.

Let me give you a scenario, very loosely based on the case.  

Mr Arshem was successful. He created and funded a family limited partnership with real estate, stock and securities. He began a multi-year gifting sequence to his children, each time claiming a generous discount for lack of control and marketability. He had cumulatively gifted away $5 million in this manner.

He passed away early in 2019. He died with an estate of $6 million.

On first pass, $6 million plus $5 million equals $11 million. He is just under the threshold, so he should not have an estate tax issue – right?

Not so fast.

The IRS audits one or more of those gift tax returns. They argue that the discounts were too generous, and the reportable gifts were actually $8 million. The estate disagrees; they go to Court; the estate loses.

Now we have $8 million plus $5 million for $13 million.

There is an estate tax filing requirement.

And estate tax due.

Let’s say that the estate had been probated and closed. There no estate assets remaining.

Who pays the tax?

Look over this little beauty:

§ 6324 Special liens for estate and gift taxes.

(a)  Liens for estate tax.

Except as otherwise provided in subsection (c) -

(1)  Upon gross estate.

Unless the estate tax imposed by chapter 11 is sooner paid in full, or becomes unenforceable by reason of lapse of time, it shall be a lien upon the gross estate of the decedent for 10 years from the date of death, except that such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration, allowed by any court having jurisdiction thereof, shall be divested of such lien.

(2)  Liability of transferees and others.

If the estate tax imposed by chapter 11 is not paid when due, then the spouse, transferee, trustee (except the trustee of an employees' trust which meets the requirements of section 401(a) ), surviving tenant, person in possession of the property by reason of the exercise, nonexercise, or release of a power of appointment, or beneficiary, who receives, or has on the date of the decedent's death, property included in the gross estate under sections 2034 to 2042 , inclusive, to the extent of the value, at the time of the decedent's death, of such property, shall be personally liable for such tax.

It is not the easiest of reading.

What (a)(2) means is that the IRS can after the transferees – the children of Mr Arshem in our example. There is also a sneaky twist. Income tax liens have to be recorded; estate tax liens do not. They are referred to as “silent” liens and can create unexpected – and unpleasant – surprises.  You cannot go to the courthouse and research if one exists.

What if Arshem’s children received his assets and thereafter sold them? What happens to the lien?

The children are “transferees.” They are personally liable for the estate tax.

COMMENT: There are procedures to possibly mitigate this consequence, but we will pass on their discussion in this post.

The case is U.S. v Ringling. The moral of the story is – if the estate is large enough to draw the wrath of the federal estate tax – please consult an experienced professional. Think of it as insurance.

Captain Eddie’s Firefly

The case starts with:

Edward G Kurdziel is the only man in America licensed to fly a Fairey Firefly. He is also the only man in America who has a Firefly to fly.”

I was immediately hooked.

What is a Fairey Firefly?

The Firefly entered service as a carrier-based fighter for the Royal Navy toward the end of the war (WW II - CTG), and became a specialist in antishipping and antisubmarine warfare.”

Mr Kurdziel – also known as Captain Eddie – explained that the Firefly “was the first British airplane to fly over Japan and Tokyo in 1945 during the [occupation] of Japan.”

In the fall of 1993 Captain Eddie learned that a Firefly was for sale in Australia. He travelled; he consulted with mechanics. The plane had not flown in years, possibly decades.

He borrowed against his house and bought the plane for $200,000. It cost another $60,000 to have it shipped.

The plane is a near-museum piece. What was he going to do with it?

His early plan was to sell rides on the plane. He looked into insurance (can you imagine?). He collaborated with the Royal Australian Navy on a plan to restore the plane.

That took eight years, 45,000 man-hours and as many as 10 full-time workers.

Captain Eddie was a bit of an Anakin Skywalker, designing and crafting many replacement parts himself.

In 2002 he received an “air worthiness certificate” from the FAA. He also got the FAA to license him to fly it. To this day, he is the only person in the country with such a license.

He showed the plane. It won prizes. It landed on 20 or 30 magazine covers.

This being a tax blog, there has to be a tax angle. What you think it was?

Yep, Captain Eddie deducted everything.

Problem: to pull this off, Captain Eddie had to persuade the IRS – and then the Court – that he actually had a business. As opposed to … say … a hobby. A really cool hobby, but a hobby nonetheless. A business has to have the intent – perhaps misplaced but nonetheless sincere – that it will show a profit.

How was this old warbird going to show a profit after the near-herculean effort and cost of restoring it?

Rides? Nah, that was nixed immediately by the authorities. No surprise that the FAA was not too keen with public rides on an antique, near-unflyable-by-today’s-standards airplane.

There were airshow appearances and prizes.

Yes, but the winnings were a pittance against what he spent. No chance of a profit there.

The Firefly crashed in 2012. Captain Eddie is still working on its repair.

The IRS brought out its hobby loss hammer and said “no deduction here.”

Off to Court they went.

Captain Eddie had to show that a sane businessperson would keep putting money into a money pit. Granted, one may do it for love, for respect for history or other reasons, but those reasons are not business reasons.

But it can happen. Take thoroughbred horses, for example. The odds of winning the Derby are miniscule, but the payoff is so great – especially if one can win the Triple Crown – that the activity can still make business sense.

Captain Eddie had an ace in his hand: he could sell the plane for a profit.

Mind you, there are a number of factors the Court could consider, such as:

·      Manner in which the activity is conducted

·      Expertise of taxpayer or advisors

·    Time and effort expended by taxpayer

·      Success on carrying on other similar activities

·      History of income or loss

·      Amount of occasional profits, if any

·      Taxpayer’s financial status 

·      Elements of personal pleasure or recreation 

·      Expectation that assets used in activity will increase in value

Captain Eddie won and lost some of these. For example, he received retirement pay pushing $180K from the Navy and Delta. He could afford an expensive hobby. There was no question about the pleasure he derived from the Firefly. He had a real estate business, but that it was a stretch to argue that it was “similar” to the Firefly.

At trial, Captain Eddie brought in experts who testified the plane was worth between $3.5 and $8 million. That would cover the approximately $1.9 million Captain Eddie had put into it.

The IRS quickly pointed out the plane crashed and had not flown since.

But planes can be repaired….

The Court acknowledged that Captain Eddie could have made money by selling the plane, but then it wondered why he did not sell it years before, when it was winning all those awards. That would likely have been its peak price.

The Court considered all the pieces.

• Initially Captain Eddie had thought of selling rides. The Court was unimpressed. A moment’s research would have told him there was no chance the FAA would allow this.
• A businessperson would respond by revising the business plan. The Court was looking at things titled “Original Plan 1999-2000?,” which did not increase its confidence that Captain Eddie had landed on his feet. 
• He had listed the activity on his personal tax return as “airplane leasing,” The Court was not humored, as nothing had ever been leased. 
• He filed a local property tax exemption for the Firefly, stating that he was not using it for commercial purposes or holding it for sale. 
•  Oh oh
• If he had thought of selling the plane, he waited a long time – 2014 – before obtaining an appraisal. The Firefly was rocking it in the early aughts – many years before 2014. 

It didn’t add up. The Court was bothered by the rides, as that would have taken minimal effort to discover. Why didn’t Captain Eddie entertain offers for the plane? Why would he sign property tax paperwork saying the plane was personal and not commercial-use or held for sale?

The Court said hobby. No loss for Captain Eddie.

A taxpayer can win a hobby loss challenge. It happens quite a bit, actually. The key is that the taxpayer should respond as a businessperson would. If one door shuts the taxpayer must show that he/she went after another open door, always with the objective of making a profit. Maybe it played out, maybe it did not – but the taxpayer tried.

And it helps to be consistent, the one thing Captain Eddie failed to do.

Our case this time is Edward G. Kurdziel, Jr v Commissioner.