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.

A Representative’s Tax Proposal for Credit Card Debt Forgivenesss

I am reading that Representative Scott Peters (D-CA) has proposed a change to the tax Code allowing forgiveness of credit card balances to be nontaxable.

I have two questions for you:

First, what is it with politicians from California?

Second, did you know that credit card forgiveness was taxable?

The tax Code is based on the concept of an increase in net wealth. The concept is simple, although it causes difficulty in application. Let’s look at the following example:

           

Monday morning you have to your name					400
Tuesday the credit card company forgave					125
Friday you got paid					1,000
You put gas in your car					(60)
You bought lunch all week					(40)
Friday afternoon you have to your name					1,425

You went from being worth $400 to being worth $1,425. Does that mean that you have $1,025 of income to report to the tax man? No, but you are thinking along the correct lines. Not every addition in our example is taxable, and not every subtraction is deductible. Let’s look at each.

•  $125 of your credit card balance was forgiven.

Code section 108 addresses the taxability when somebody forgives your debt. There are five subcategories:

·        108(a)(1)(A) applies in bankruptcy

·        108(a)(1)(B) applies if you are insolvent

·        108(a)(1)(C) applies to farm debt

·        108(a)(1)(D) applies to certain business debt

·        108(a)(1)(E) applies to your mortgage

I am not seeing an exception for credit cards, so for the time being it looks like the $125 will be income. I am assuming that you are not insolvent (meaning that you owe more than you are worth) or in bankruptcy (which sometimes follows owing more than you are worth).

• Your paycheck

That one is obvious. We should be thankful the government does not just decide to have all paychecks sent to them, allowing them to decide how much to return to us.

•  Buying gas and a week’s worth of lunches

Code section 262 disallows tax deductions for personal, living and family expenses. Granted, another Code section may override and allow a deduction for specific expenses (such as medical), but in general one cannot deduct groceries, utilities, rent and similar day-to-day-living expenses.

I would say that you have taxable income of $125 plus $1,000 = $1,125.

The credit card is a subset of “forgiveness of indebtedness” taxation. The seminal case is Kirby Lumber, which was decided by the Supreme Court back in 1931. Kirby Lumber had previously issued bonds of over $12 million. They later bought back the bonds for $137,000 less. The question before the Court was whether that $137,000 represented taxable income. It does seem a bit odd that someone can have income just from transacting in debt, but if you think of it as accession to wealth the tax reasoning becomes clearer. At the end of the day Kirby Lumber was worth $137,000 more (as it had less net debt), and the government wanted its cut.

Back to Representative Sun-Dance-Whispered-By-Hidden-Shadow, or whatever he is called back in his native land.

He is proposing that forgiveness of credit cards be excluded from income.

However, the most that a person could exclude from lifetime income is capped at $2,500.

Say that you excluded $1,000 in 2014. Under his proposal, the most you could exclude – over the rest of your life – is another $1,500. You cannot exclude more than $2,500 over your lifetime.

My first thought is that $2,500 is not enough to move the needle, if someone really got into credit card and personal debt problems. I have known and heard of people who have run up a mortgage-level balance on their credit cards.

My second thought is whether this is a wise use of the public purse. Congress provided a mortgage interest deduction because it wanted to increase home ownership. It provided a charitable deduction to promote societal benevolence and reduce strain on the public safety net. What is Congress saying by providing an exclusion for not repaying credit card debt?

And you can see how bad tax law happens. There is no theory of wealth creation, case precedence or administrative practicality at play with this proposal. An elected bludger panders, laws are passed without being read and the tax system (both the IRS and advisors) is left to making sense out of nonsense.    
  

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.