Although the housing market, including sales of existing homes, continues to improve overall (see "Number of Existing U.S. Home Sales"), CPAs are still likely to have clients whose difficulty in selling their home for the price they want causes them to consider converting it to property held for rental or other production of income.
Among the many considerations that tax advisers should make sure these would-be landlords understand is whether the IRS will accept that the conversion really has been made in the first place. Taxpayers still making any personal use of the property would have to observe the so-called vacation home limitations under Sec. 280A. But assuming the owners have permanently moved out, it would then seem a simple matter: Engage a real estate agent, spruce up the home to enhance its appeal, and they might think it then becomes a rental property.
Married taxpayers who offered their oceanfront condo in a resort in Palm Coast, Fla., for rent but did not sign a tenant were among the many to discover otherwise. The Tax Court recently upheld the IRS's denial of an ordinary loss and other deductions claimed by Robert and Pamela Redisch with respect to their former second home (Redisch, T.C. Memo. 2015-95).
The couple purchased the condo in 2004 for $875,000, made improvements, and used it seasonally. They decided to stop using it in 2008 after their daughter, who had spent time with them there, died. They chose to rent it out while they waited for the housing market to recover, when they hoped to sell it at a profit. They signed a contract with the realty company that marketed other properties in the resort community and set a monthly rental price based on discussions with real estate agents and their own experience of having rented there before purchasing the condo. The Redisches received inquiries from only two potential tenants. Neither followed through, and the Redisches offered the condo for sale in 2009, finally selling it for $725,000 in late 2010, when their tax basis was $884,975.
The IRS disallowed a claimed ordinary loss on the sale and other deductions related to the property claimed on Schedules E, Supplemental Income and Loss, for 2009 and 2010 and assessed accuracy-related penalties.
In regard to the presale expenses for the condo that the Redisches deducted, the Tax Court explained that no deduction is allowed for personal, living, or family expenses, such as those of a home to the extent it is used by the taxpayer personally (Sec. 262(a)). However, for a home converted to rental property, an individual can deduct ordinary and necessary expenses of managing, conserving, or maintaining property as expenses of property held for the production of income (Sec. 212(2)). The individual bears the burden of proving that the conversion occurred and that profit was its primary motive. Whether such a conversion occurred is determined by the facts and circumstances.
For determining the taxpayer's intent in such cases, the Tax Court noted that it often looks at five factors: (1) how long the taxpayer occupied the home before placing it on the market for sale; (2) whether the taxpayer has abandoned all further personal use of the home; (3) the character of the property (recreational or otherwise); (4) offers to rent; and (5) offers to sell.
A taxpayer may also be able to deduct under Sec. 165 a loss on the sale of a home that was formerly a residence as a loss incurred in a trade or business or in a transaction entered into for profit. The taxpayer can, however, deduct such a loss under Sec. 165 only if prior to its sale the residence is "rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of its sale" (Regs. Sec. 1.165-9(b)(1)).
The Tax Court held that the Redisches did not make a bona fide attempt to rent out their condo, so it was not converted to a rental property. Consequently, it was not property held for the production of income, so the presale expenses were not deductible under Sec. 212 and the loss on the sale of the condo was not deductible under Sec. 165. Rather than applying the five-factor test, the court primarily based its determination on what it called the Redisches' "minimal effort" to rent the home. Evidence at trial indicated the realty company did not market the home beyond the resort community but only featured it in a portfolio in its office and told prospective buyers when showing it as a model that it was available. The court sustained penalties as well.
Previous cases shed more light on the court's application of the five factors:
How long the home is occupied before it is placed on the market for sale. This factor has been applied to determine an intent to hold property for post-conversion appreciation. Placing a property on the market soon after abandoning its personal use has been held to indicate a lack of intent to hold it for appreciation (see, e.g., Murphy, T.C. Memo. 1993-292, and Grant, 84 T.C. 809 (1985)).
Whether the taxpayer has abandoned all further personal use of the home. The Tax Court has held this factor to be satisfied even where the taxpayer or her son visited the property semimonthly and a property listing indicated it would be occupied on weekends. The court found the visits were primarily for reasons related to the sale or rental of the property (Meredith, 65 T.C. 34 (1975)).
The character of the property (recreational or otherwise). When evidence indicates a taxpayer held property with a motive of sport, hobby, or recreation, this may militate against a finding that profit was a primary motive (e.g., Monfore, 214 Ct. Cl. 705 (1977); see also Regs. Sec. 1.212-1(c)).
Offers to rent or sell. A dearth of offers has in a number of cases besides Redisch been taken as indicating a lack of a bona fide effort and intent on the part of the renter or seller (see, e.g., Saunders, T.C. Memo. 2002-143). Although in Redisch the Tax Court noted the taxpayers had tried to make the condo more marketable by converting a bedroom into a children's room at the advice of a real estate agent, other cases have pointed to a lack of such efforts as responsible for lackluster interest from renters or buyers (e.g., Meredith, 65 T.C. at 37).
The lessons for taxpayers are many. To prove an intent to rent, it seems advisable to document vigorous efforts to market the property, preferably by multiple avenues, such as in several publications, listings, and notices, with a large and wide audience or readership. If a real estate agent is not advertising the property's availability in these ways, the taxpayer probably should get another agent who will or take matters into his or her own hands. Merely listing a property for rent will not convert it to a rental property.
In any less-than-robust housing market, taxpayers may be tempted to hold onto a property they used as a personal residence for sale in better times and to rent the property in the meantime. If so, tax advisers should caution them about the hurdles to overcome in deducting expenses from or losses on the sale of the property.
Paul Bonner is a JofA senior editor. To comment on this article or to suggest another article, contact him at firstname.lastname@example.org or 919-402-4434.