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. (Editor's Note: The Kobayashi Maru is a test in the fictional 'Star Trek' universe. This test's name is occassionally used by fans to describe a no-win scenario.)
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.”
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.
About the author
Steven D. Hamilton is a career CPA, with extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.