Short-term use prevents grouping real property activities

A district court held that management companies contracted by a taxpayer for three of his real properties did not have a continuous or recurring right to use the properties for an average of more than seven days per tax year; therefore, the taxpayer’s claimed rentals of those properties were not rental activities under Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A) and could not be grouped with the taxpayer’s other rental activities, reducing his claimed losses.

Facts: For tax years 2007—2009, Greg Eger was a real estate professional under Sec. 469(c)(7). For those tax years, he elected to treat his 33 rental properties as a single real estate rental activity that included three resort properties, one in Mexico, one in Colorado, and one in Hawaii. He entered into management agreements giving each of three outside entities an exclusive right to rent and manage one of the properties.

Under the Mexico property agreement, Eger retained the right to use that property for an unlimited number of days as long as there was no conflicting confirmed reservation for it. Under the Colorado property agreement, Eger could use the property up to 56 days in a calendar year, and more if he paid a fee, but he could not reserve it more than 365 days in advance. Under the Hawaii property agreement, Eger also retained the right to use the property for an unlimited number of days, subject to two limitations: During the first six months, Eger could use the property no more than 30 days, and at all times, he had to reserve it at least 180 days in advance.

Eger and his wife as joint taxpayers filed suit in district court after the IRS determined that the resort properties were not rental properties, that they could not be grouped with his other rental properties as a single activity, and that losses from them were nondeductible passive losses.

Issues: Generally, rental activities are considered passive, and any losses are deductible only against other passive income; however, losses from the rental activities of a real estate professional can be deducted against nonpassive income. Real estate professionals are allowed to group similar rental properties and treat them as a single activity for this purpose. Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A) states that an activity involving the use of tangible property is not a rental activity if the average period of customer use is seven days or less for the tax year. According to Regs. Sec. 1.469-1(e)(3)(iii)(D), a period of customer use of property is each period in which a customer has a continuous or recurring right to use that property.

Eger argued that two Tax Court cases previously treated property management agreement terms as periods of continuous and recurring use. In Hairston, T.C. Memo. 2000-386, the taxpayers leased heavy equipment for an indefinite term to a management company that had an exclusive right to use and sublease the equipment. In White, T.C. Summ. 2004-139, the taxpayers entered into an agreement giving a charter company the exclusive right to lease and sublease their yacht.

Eger also argued that the management companies did have either a continuous or a recurring use of the properties because he and his wife never used the properties during the years in question (later conceding that they had used the Mexico property).

The IRS agreed that Eger was a real estate professional but argued that the three resort properties were not rental activities and could not be grouped with his other real estate properties because the average period of customer use was properly determined by their use by end-user guests, which was less than seven days per year.

Holding: The court held for the IRS because Eger failed to show that the management companies had a continuous or recurring right to use any of the three properties. Unlike the taxpayers in Hairston and White, the court held, Eger retained significant rights to use the properties, so the management companies did not have exclusive access rights and only provided marketing and rental services.

The court rejected Eger’s argument that continuous use of the properties should be determined by their actual use. Because the couple never actually used the Colorado and Hawaii properties, he argued, the management companies had continuous use of them. The court found that the actual use of the property did not matter because Regs. Sec. 1.469-1(e)(3)(iii)(D) refers to “the right to use” the property, not its actual use.

The court also stated that even if it found that the management companies had a recurring right to the properties, the properties were not rental activities because Eger did not show that the average period of customer use was more than seven days, due to his retained rights to use the properties.

• Eger, No. 18-cv-00199 (N.D. Cal. 8/30/19)

— By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.