Issue
If a taxpayer converts a home to a rental, when can the taxpayer deduct any losses related thereto?
Related Tax Rules or Regulations
Internal Revenue Code Section 262, which provides that except as otherwise expressly provided, no deduction is allowed for personal, living, or family expenses.
Internal Revenue Code Section 165 permits a deduction for any “loss sustained that is not otherwise compensated for.” In order for an individual to deduct such a loss, the loss must be incurred in a trade or business, be incurred in any transaction entered into for profit, though not connected with a trade or business, or arise from some sort of casualty or theft. If such property purchased or constructed as a primary residence if, before its sale, it is “rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of sale.”
Facts
The taxpayers bought a beach-front condominium in Florida for $875,000 in 2004. The home was used as a seasonal residence but not as a personal residence until 2008, when the taxpayers moved out of the home. The real estate market had begun to fall, however, the taxpayers were apparently confident that the market would rebound and the value would again increase enabling them to sell it in the future for a profit. As a result, they decided to convert the house to a rental for this interim period.
To facilitate finding a tenant, the taxpayers hired a realtor and planned to remodel one of the rooms. The taxpayers then moved out and soon thereafter removed all of their personal belongings from the residence. The taxpayers ultimately only received inquiries from two interested potential renters without either of them agreeing to sign a lease. Having failed to find a tenant, the taxpayers listed the home for sale in 2009, and ultimately sold it in December 2010 at a loss.
On their 2010 tax return, the taxpayers deducted a loss from the sale of the home, arguing that by moving out in 2008 and seeking to rent the home, they had converted the use of the home from residence to rental activity “entered into for profit,” and were thus permitted a deduction under Section 165(c).
Decision:
The IRS disagreed, arguing that because the taxpayers never rented the home, the use of the home was never successfully converted into an income-producing property, and thus any loss on the sale of the home was disallowed by Section 262.
In reaching its conclusion, the Tax Court considered and analyzed five judicially-established factors often used to determine if a taxpayer has changed his or her intent in owning a home from a principal residence to a rental property for tax purposes:
- The length of time the house was occupied by the individual as his residence before placing it on the market for sale;
- Whether the individual permanently ceased all further personal use of the house;
- The character of the property (recreational or otherwise);
- Offers to rent; and
- Offers to sell.
Note that the actual execution of a lease agreement is not one of the factors. In the absence of such an agreement, the taxpayer has the increased burden to show that every effort was made to find a renter, including advertising the home in a significant number of locations. In this case, the realtor only showed the home as a model for others in the area. And, to some extent it didn’t help that the home was never rented. The taxpayers were hardly patient with leasing the property before deciding to sell as they placed it on the market soon after the attempt to lease. There were only had two interested parties in twelve months and neither made an offer to lease.
This suggests, arguably, that perhaps the taxpayers didn’t expend the requisite effort to demonstrate that the property was truly a rental for tax purposes under IRC §165(c). In analyzing the factors, the court ultimately concluded that the totality of the evidence revealed that the taxpayers did not make a sufficiently legitimate attempt to rent the property, and therefore did not convert it to one held for the production of income.
What It Means
The regulations provide that an individual can claim a loss under Section 165(a) on property purchased or constructed as a primary residence if, before its sale, it is “rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of sale.” Thus, a taxpayer facing a large loss on the sale of their home may move out, convert the home to a rental, and after a period of time, sell the home for a loss and recognize the loss that would otherwise been unavailable had the house remained their primary residence.
Despite the absence of an actual lease as one of the five factors discussed above, it is nevertheless generally recommended that taxpayers rent the home for more than one year in order to establish a rental intent. Otherwise, there is a chance that the IRS may perceive such undertaking as the taxpayer acting with the sole purpose of procuring a deductible loss upon subsequent sale. Similarly, the taxpayer should not list home for sale immediately after converting the home to a rental since this typically indicates a primary intent is to sell the home rather than to generate a profit from renting the home.
The divergent treatment of a loss on the sale of a primary residence and a rental home clearly gives rise to a planning opportunity. If your primary residence has declined in value — as many have — why sell the home and generate a nondeductible personal loss when instead, you can convert the home to a rental, then sell the home, and recognize a loss for tax purposes under Section 165? If you have questions about whether a residence that you own may be viable as a rental property, call THE TAX EXPERTS AT THE Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
