Small Business Taxes & Management^TM--Copyright 2015, A/N Group, Inc.

Introduction

Converting personal use property to a rental can make sense if you're not using the property, have difficulty selling it, etc. The situation can occur with a vacation home that's in another part of the country, a former home in a bad real estate market, an inherited property, etc. You should be able to deduct real estate taxes whether the home is vacant or occupied. Mortgage interest could be trickier. You can deduct mortgage interest on your principal residence and a second property, so if this is your second home, it should be deductible (but not always; check the other rules for mortgage interest). In addition, if the property is held for the production of income you can claim a loss on the sale as an ordinary loss. If not you can't deduct other upkeep expenses such as electric, heat, maintenance, homeowner's association fees, etc. and any loss on the sale won't be deductible.

What if the property is available for rent, but not rented? At what point can you deduct other expenses? That depends on the facts and circumstances and it was the situation in a recent case, Robert I. Redisch et ux. (T.C. Memo. 2015-95).  

The Case

The taxpayers purchased a condo in Florida for $875,000 in April 2004. They used the property as a seasonal home until a personal tragedy in 2006 when they decided they could no longer stay in the property. Rather than selling, in 2008 they decided to rent it out because they believed that they could sell it later at a profit while generating cash in the short term.

The husband contacted a realtor to assist in renting the property. The condo community was still under development and the realty company showed potential purchases properties within the community, including those that were newly constructed. The taxpayer selected this company because most of its realtors lived in the community and he believed they would be in the best position to rent out the property. The taxpayers testified he entered into a one-year contract with the realty company around April 2008. The taxpayers intended to rent the furnished property under a one-year lease that included the option to assume the husband's golf membership. The rental price was determined after discussions with realtors and his past experience in renting in the community.

The taxpayers had stopped staying in the property after the personal tragedy. In April they removed most of their personal belongings, but would visit the property to ensure it was suitable for showing. They kept the unit available for rent and changed one of the rooms into a child's room to increase the possibility of finding a tenant. The Court noted the taxpayers presented no evidence to show the efforts that the realtor took to market the property outside of the community.

When in the area the taxpayers did not stay in their condo, but with a friend who owned a unit in an adjacent building. The taxpayers received inquiries from two potential renters. However, neither rented the property because one wanted only a two-month rental and the other had a large dog, both of which conflicted with building restrictions. Because of lackluster interest in renting the property the taxpayers put it on the market for sale. They still hoped to rent but were considering other options such as selling or leasing to own because other owners in the building were losing their properties to foreclosure. In December 2009 the taxpayers sought an appraisal to price it more competitively. It sold for $725,000 in December 2010.

The taxpayers claimed deductions related to the property on Schedule E Supplemental Income and Loss of their Form 1040 for 2009 and 2010. The IRS disallowed their deductions and the taxpayers petitioned the Tax Court. They amended the petition to claim an ordinary loss on the sale.

The Opinion

Generally, while personal expenses are not deductible, an individual can deduct all ordinary and necessary expenses paid or incurred during the taxpayer year for the management, conservation, or maintenance of property held for the production of income. The taxpayer bears the burden of proving that a conversion to a profit-motivated purpose occurred. (Emphasis added.) That burden cannot be satisfied if the profit-motivated purpose was secondary to another purpose not motivated by profit. Whether an individual converted his personal residence to one held for the production of income is a question of fact that depends on the purpose or intention of the individual, as gleaned from all of the facts and circumstances. The court often looks to five factors to determine the taxpayer's intent:

1. the length of time the house was occupied by the individual as his residence before placing it on the market for sale;
   
2. whether the individual permanently abandoned all further use of the house;
   
3. the character of the property (recreational or otherwise);
   
4. offers to rent; and
   
5. offers to sell.

In addition, if the individual offers his house only for sale, then in order to be treated as holding the property for the production of income he must intend to realize gain representing postconversion appreciation in the fair market value of the property.

As is usually the case, no one factor is determinative and all of the facts and circumstances are considered.

Here the Court found the property was not converted to a rental unit. Some of the points cited by the Court:

• The taxpayers used the property for personal purposes for four years before abandoning personal use.
  
• The taxpayer claimed he had a one-year agreement with the realty company to rent the property yet did not provide evidence of such.
  
• Even if the contract was produced, the efforts made by the realty company were minimal.
  
• The taxpayer didn't take additional steps, other than changing agents, to rent the property.

The Court found the taxpayer did not make a bona fide effort to rent the property. The Court denied the taxpayers a deduction for expenses on Schedule E and a loss deduction on the sale.

Other Points

On first glance, renting or attempting the rent the property and taking deductions on Schedule E would be a relatively easy option for unused property. But it's not that simple. Taxpayers have lost in several other cases.

Here it would seem the taxpayers honestly tried to rent the property without success. But the Court thought otherwise. For one thing it thought the taxpayers didn't try hard enough to rent. We're not sure what would have satisfied the Court, but consulting additional realtors, getting an appraisal with respect to the fair rental value early on, promoting the property in some way, etc. That's easier said than done, particularly in a poor market. One thing is interesting, the Court was looking for documentation, even though it may not have helped much here. Keeping records of your attempts, copies of letters or e-mails, copies of appraisals and agreements and ads, even a diary recording phone calls and meetings could help bolster your position. At least you've done your best and won't be denied for lack of documentation.

Your initial intent can be important. Did you intend to permanently abandon the property? Removing all your personal belongings and moving to a new home could be one indication of an intent to rent, particularly if you don't have to sell the property to buy the new home. Severing ties to the home such as club memberships, mailing addresses, voting registration, etc. Your tax advisor may have more suggestions.

Fixing up the home to prepare it for rental (new appliances, updated bath, new paint, etc.) could be another indication.

Document special problems in securing tenants or getting the property rentable. For example, in order to rent a house the town requires a permit or conformation to new codes and it takes time to comply.

If you're required to notify third parties of your intention to rent such as the town, your insurance company, etc., do so. If you're having work done by a contractor and it's in any way relevant, inform him you're making it into a rental.

Renting at less than a fair market rent could be fatal (particularly if the rental is to a related party). Get two appraisals of the going rent in the area.

The best indication of conversion to rental is actual rental income. You might have to accept less than the ideal tenant. No pets? You might make an exception for small dogs or cats. Or be flexible on terms.

Keep in mind that the hobby loss rules can be applied in some circumstances and losses are subject to the passive activity loss limitation rules. Here are two examples that might make it clearer.

Example 1--Fred and Denise lived in Chatham. Denise's parents lived close by in Wilmington. After they pass away Denise inherits their house, a slightly larger, newer property on a lake. They move into the Wilmington house, taking all their personal belongings and furnishings. Fred keeps his golf club membership in Chatham, but it's only 10 miles from Wilmington. After updating the bath, electrical and mechanical systems and painting all the rooms, they put the house on the rental market. Because of a poor market (a local business closed its doors) the Chatham house languishes. After four months on the market Denise convinces the original local realtor to accept a second realtor with a regional rental base. She also creates a Web site for the property with more pictures, local information on schools, etc., and offers tenants one month free rent on renewal. After 22 months the property is rented. Three months before each lease expiration, she approaches the tenants to determine if they intend to renew. Subsequently, with short vacancies the house is rented for four years. Three months before each lease expiration, she approaches the tenants to determine if they intend to renew. Because they need money for their daughter's college they sell the home for less than what they paid for it and less than the fair market value at the time of conversion. They should be able to deduct any rental losses and the loss on the sale.

Example 2--Mark and Sue have owned and used a vacation property on a small lake not far from their main home for many years. Because of Sue's new job the couple rarely spend more than a week during the summer. They attempt to rent the property but have had little success because the house is tired. Other than one or two one-week rentals during a season there have been few renters. Several prospective renters have been rejected because of pets. It's unlikely the IRS or a court would allow the losses.

--Last Update 07/06/15