Posts Tagged ‘passive losses’

Tax Roundup, 2/13/2013: The President wants more taxes. Because they’re doing such a good job with what they get now.

Wednesday, February 13th, 2013 by Joe Kristan

State of the union:  raise taxes more.  It will never be enough.  If you think we don’t have a spending problem, or think we can solve it through “closing loopholes,” check out three charts gathered by Veronique de Rugy:

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20130213-3

The President proposes nothing serious.

Breaking news from yesterday: Look for a Call to End Oil “Subsidies” in Tonight’s State of the Union (Andrew Lundeen, Tax Policy Blog)

Howard Gleckman, Obama’s State of the Union and the Great Deficit Smackdown (TaxVox)

 

How H&R Block guy got to write preparer regs.  Civil Service! Tim Carney reports:

In 2009, the Obama administration hired Mark Ernst, the previous CEO of tax prep giant H&R Block, as IRS deputy commissioner. Ernst became a “co-leader” (in the words of an IRS spokesman) in drafting new regulations for tax preparers.

This seems to clash with President Obama’s executive order barring appointees from working on regulations directly affecting their former employers.

But thanks to a fine legal distinction, these rules didn’t cover Ernst. “Mark Ernst is a civil servant at the IRS; he is not a political appointee,” an IRS spokesman wrote me. “The Presidential Executive order on Ethics Commitments by Executive Branch Personnel only applies to political appointees.”

Nobody here but us chickens.

 

Jason Dinesen has a new installment about his client whose identity was stolen in the ID theft epidemic that really got rolling while the IRS was busy regulating preparers.  “If you hired the best comedy writers and satirists in Hollywood, they couldn’t come up with a more farcical script about government ineptness.”

Speaking of government competence:

Not only will most farmers have to file after March 1, 2013 due to a delay in tax forms by the IRS, we  now have an announcement that almost all form 1099s issued by the USDA for Natural Resources Conservation Services payments in 2012 are either wrong or were never issued.

via Paul Neiffer.

 

David Brunori, If You Hate or Love Excise Taxes Read this New Report:

A new working paper  recently released by the Mercatus Center at George Mason University… finds that contrary to conventional wisdom, sin taxes are often not used to correct externalities but rather for general fund spending. My take on that is politicians don’t really care about externalities. They would like to raise money from people whose activities they despise. The report also found that the goal of “sin taxes” has changed from correcting market failures to protecting consumers from their own choices. That is, people are too stupid to run their own lives and they need help. Finally, the report finds that sin taxes are regressive, i.e., they punish the poor. Unfortunately, my liberal friends never get exercised over this issue. Maybe it’s as the great PJ O’Rourke surmised, liberals hate poor people. 

If they would just not wear those icky Wal-Mart clothes and watch their weight, like they tell them to… (Tax.com)

 

Peter Reilly,Even Real Estate Salesman Has Trouble With Passive Loss Exception

Even accepting that he spent 520 hours working on his own properties, he still lost.  Two of the properties were short-term vacation rentals and one was being readied for sale.  The time spent on those properties could not be grouped with the time spent on properties dedicated to long term rentals.

As Peter notes, this becomes an even more important tax issue with the new 3.8% tax on “passive” income this year.

 

Kay Bell,  When will you get your tax refund? Whenever

Trish McIntire, Child Tax Credit Delays

TaxGrrrl, Spammers Target Taxpayers Expecting Tax Refunds.  If you get an email about your refund from the IRS, it’s not from the IRS.

Jack Townsend, Another Bull**** Tax Shelter Bites the Dust

Roger McEowen, Another Court Issues Ruling on Tax Impact of Demutualization.

Tax Trials,  Second Circuit: Co-Op Owner Is Entitled to Casualty Loss

Patrick Temple-West, Navigating between tax avoidance and evasion, and more

Gene Steurle, Desperately Needed: A Strong Treasury Department (TaxVox)

Robert Goulder, La Bella Italia: Fast Cars & Loose Taxes (Tax.com)

Jim Maule, When Spending Cuts Meet Asteroids: The Value of Taxes.  Taxes and spending can never be too high because, you know, asteroids!

The Critical Question.  Minnesota’s Sexiest Accountant Contest: Cute or Creepy? (Going Concern)

 

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Tax Court keeps taxpayer mistake from triggering the “self-rental” passive income rule.

Wednesday, November 14th, 2012 by Joe Kristan

Cell tower image courtesy Wikpedia Commons

The tax law “passive activity” rules were written to shut down real estate shelters by making rental losses “passive,” deductible only to the extent of “passive” income.  About 3 seconds after the rules were enacted, taxpayers began thinking of ways to generate passive income so they could deduct their passive losses by renting land or by renting property to a controlled business activity.  Rules treating “land rent” or “self-rental” net income as non-passive were issued quickly to stop that.

The new Obamacare 3.8% tax on “investment income” will apply to “passive income” as determined under the passive loss rules, so a  Tax Court decision issued yesterday exploring these issues takes on added importance.

The taxpayer leased land with cell-phone towers to his wholly-owned S corporation.  The S corporation in turn leased the towers to phone companies.  The taxpayer also leased land to his S corporation.

The S corporation mistakenly reported the income from its leases to the phone companies as ordinary income, rather than rental income, lumping the tower rental with the S corporation’s other business income.  The taxpayer treated the income as non-passive.

The towers leased to the S corporation were reported as passive leases on the taxpayer’s 1040, as were the land rents.  Some tower leases were profitable while others generated losses, but because they were all reported as “passive,” the losses and income offset.

The IRS had other ideas. The IRS left the K-1 income as non-passive, saying that the leases to the phone company wasn’t really “rental,” and in any case the taxpayer was stuck with the way the income was reported.  The IRS split the income from “self-rental” of the towers to the controlled corporation,  with the losses treated as passive and the income reclassified as non-passive under the self-rental rules.   The bottom line: a lot of non-passive income that couldn’t be offset by the now non-deductible passive losses.

The Tax Court said the IRS was being too cute.  The IRS said that the taxpayer was bound by his treatment of the S corporation tower income as non-passive because he had already grouped it with his other activities.   Judge Halpern said the IRS regulations didn’t have to cause such a harsh result.  While the taxpayer might be stuck with its return reporting for determining whether to report income from the K-1 as passive, that didn’t extend to the self-rental rules. so the taxpayer didn’t have to split up the cell-tower rental to the S corporation between profitable (non-passive) and loss-generating (passive):

We recognize that, because ICE erroneously reported all of its income as ordinary business (non-passive-activity) income, nonapplication of the self-rental rule of section 1.469-2(f)(6), Income Tax Regs., to ICE’s rental payments to petitioner, in effect, results in the reduction of what was reported as “active business income” and the offsetting creation of “passive income” in seeming contravention of the congressional conferees’ directive to issue regulations preventing that result. See H.R. Conf. Rept. No. 99-841 (Vol. II), at II-147 (1986), 1986-3 C.B. (Vol. 4) 1, 147. We do not believe, however, that ICE’s tax return mischaracterization of its tower access rental income from third parties should control the application of the self-rental rule where, as here, it is, by its terms, inapplicable, i.e., where petitioner’s towers were not, in fact, used in a trade or business. Moreover, we are not persuaded that the result we reach herein violates the conferees’ directive as it does not, in fact, permit “passive income” to offset “active business income”.

The Tax Court upheld the IRS in treating the land-rental as non-passive.

The Moral?  The Tax Court reached a fair result, even though it had to stretch around the regulations to do so.  Had the towers been rented to the S corporation for use in its non-passive business, the judge would probably have given the IRS its “heads I win, tails you lose” treatment — the income would have been non-passive, and the losses would have been passive and non-deductible.  The result was different because the S corporation in turn leased the properties to third parties, instead of using them in its non-passive business.

The result is fair because the taxpayer isn’t really generating improper passive income that wouldn’t be there if it had reported the income on the K-1 properly in the first place.

This case reminds us how important it is to identify your passive activities and group them properly.   With the 3.8% tax on passive income taking effect in January, this is even more important.

Cite: Dirico, 139 T.C. No. 16.

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“Self-Rental rule” trips up trucking company

Thursday, August 9th, 2012 by Joe Kristan

http://www.rothcpa.com/misc/20090115-1.JPGThe perennial tax problem for owners of “C corporations” is getting cash out of the corporation without it being taxed twice.  Unlike “S corporation” income, C corporation income is taxed twice: first under the corporate income tax rules when it is earned, and again as taxable dividend income when distributed to the shareholders.

A common tactic to extract C corporation income without a second tax is to rent property to the corporation.   While the owner has to report the rental payments as income, the corporation gets a rental expense deduction, netting to only one tax.  But this plan has its own risks, as a C corporation owner learned yesterday in Tax Court.  The Tax Court held that the “self-rental” rule kept the taxpayer from deducting rental losses from leases of equipment to his corporation.

Tax Court Judge Wells sets the stage (my emphasis):

Mr. Veriha is the sole owner of John Veriha Trucking, Inc. (JVT), a corporation with its principal place of business in Wisconsin. JVT was a C corporation during 2005 but has since elected S corporation status. Petitioners were both employed by JVT during 2005, and Mr. Veriha materially participated in JVT’s business. JVT is a trucking company that leases its trucking equipment from two different entities, Transportation Resources, Inc. (TRI), and JRV Leasing, LLC (JRV). The trucking equipment JVT leases consists of two parts: a motorized vehicle (tractor) and a towed storage trailer (trailer).

     TRI is an S corporation in which Mr. Veriha owns 99% of the stock; his father owns the remaining 1%. TRI is an equipment leasing company with its principal place of business in Wisconsin. TRI owns only the tractors and trailers that it leases to JVT. During 2005, TRI and JVT entered into 125 separate lease agreements, one for each tractor or trailer leased. TRI’s only source of income during 2005 was the leasing agreements with JVT.

     JRV is a single-member limited liability company, and Mr. Veriha is its sole member. JRV is an equipment leasing company that owns only the tractors and trailers that it leases to JVT. During 2005, JRV and JVT entered into 66 separate lease agreements, one for each tractor or trailer leased. JRV’s only source of income during 2005 was the leasing agreements with JVT.

In 2005 TRI had income from its rental, but JRV, the single member LLC, reported a loss.  Rental income and loss is normally “passive,” and passive losses are only deductible to the extent of passive income.

When the passive loss rules were enacted, the IRS feared that business owners would set up deals with their businesses to generate passive income, enabling them to deduct otherwise deferred passive losses.  To combat this, the IRS issued regulations holding that net income from renting to your own business would not be passive if the income from the business isn’t itself passive.  The IRS used these regulations to keep Mr. Veriha from deducting his rental losses against his rental income.  The taxpayer argued the losses of JVT should be lumped together with the income from TRI, with only the net income of the two treated as non-passive.

The Tax Court sided with the IRS:

Section 1.469-2(f)(6), Income Tax Regs., explicitly recharacterizes as nonpassive net rental activity income from an “item of property” rather than net income from the entire rental “activity”. Section 469 and the regulations thereunder distinguish between net income from an “item of property” and net income from the entire “activity”, which might include rental income from multiple items of property.

we conclude that each individual tractor and each trailer was a separate “item of property” within the meaning of section 1.469-2(f)(6), Income Tax Regs. However, because respondent has not contested petitioners’ netting of gains and losses within TRI, only TRI’s net income is recharacterized as nonpassive income.2

That last sentence has to be scary to anybody renting multiple properties, like a trucking fleet, to a controlled business.  The Tax Court is saying that the IRS could have required the taxpayer to determine the income from each truck and tractor leased to the business, with all income leases non-passive and all losses passive.  The Tax Court in its footnote spells it out:

We note that this result is necessarily more favorable to petitioners than the result would have been had respondent contended that it was necessary for the income from each tractor or trailer within TRI and JRV to be recharacterized as nonpassive.

That implies that the IRS was just being “nice” this time, and another taxpayer with similar facts could do much worse.

The moral: Taxpayers who rent to their own businesses — at least those in which they “materially participate” —  need to remember that they can’t offset passive losses with that rental income.  If they rent many items to their business, they need to make sure that every lease generates a profit, or the IRS might split them out and disallow all the losses.

Cite: Veriha, 139 T.C. No. 3.

More on the passive loss rules here.

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Understanding your partnership K-1: can you deduct that loss?

Tuesday, April 3rd, 2012 by Joe Kristan

Flickr image by naotakem under Creative Commons licenseLife is always easier when you’re making money.  The problems of prosperity are much more pleasant than those of poverty.  That’s also true when your partnership is losing money. 

Yesterday we showed how a K-1 works.  Today we cover the special problems of K-1s that show losses.  Just as the owners of a partnership pay income taxes on partnership income, they get to deduct the losses, too, right?

It depends.  There are three hurdles that a K-1 recipient has to clear to deduct K-1 losses. 

The first hurdle is basis. Your basis starts with your investment in the K-1 business; it is increased by income and cash contributions and decreased by losses and distributions. In partnerships  — but not S corporations — an owner’s basis may include a portion of the company’s borrowings from third parties.

Unfortunately, the K-1s do a poor job of tracking owner basis.  You, or your tax preparer, may need to keep a separate schedule of your basis to determine whether you might deduct K-1 losses.

The next hurdle is whether your basis is “at-risk.” The “at-risk” rules are an obscure leftover of tax shelter battles of the 1970s, but they still apply.They can be very complex, but their gist is that if your basis is attributable to borrowings that are “non-recourse” — that you aren’t personally liable for — it is not “at risk,” and losses attributable to that basis must be deferred. You may also not be considered “at risk” for related-party borrowing, especially if you borrow from your business or from a business associate to fund your ownership in the K-1 issuer.

Partnership K-1s provide some useful information in determining whether you have an “at-risk” issue. If you have losses in excess of your cash investment, and your share of debt on the K-1 part K is on the “nonrecourse” line, you are likely to have an at-risk problem. You will have to go to IRS Form 6198 to figure out whether you have to defer losses under the at-risk rules.

The “passive loss rules” are the final hurdle for deducting K-1 losses. These rules were enacted in 1986 to shut down that era’s tax shelters. If you have “passive” losses in excess of “passive” income, you have to defer the losses until you have passive income in a future year, or until you dispose of the “passive activity” in a taxable transaction.

A loss is “passive” if you don’t “materially participate” in the business. There are a number of tests that you can use to determine whether you materially participate, but the most common is working at least 500 hours in the business in a year. 

Real estate rental is passive by law, unless you are a “qualifying real property professional.”  Special rules keep you from generating “passive” income to allow you to deduct passive losses. For example, land rent and most investment income is not considered “passive” under these rules. The passive loss limitation is computed on Form 8582.

These rules are complicated, even for tax pros. If you aren’t sure where you stand, and the losses are significant to you, get in touch with a tax pro.

A version of this item previously appeared at IowaBiz.com.

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You want to deduct that loss? Be ready to prove you are non-passive

Thursday, January 19th, 2012 by Joe Kristan

A Tax Court case yesterday illustrates the problems taxpayers with day jobs face when they want to deduct losses for side activities. A Minnesota entrepreneur named Alfred Iverson, who founded a successful manufacturer of surgical and medical equipment, also had a 14,000 Colorado ranch where he raised Angus and Herford cattle. The ranch generated tax losses in 2005 and 2006, and the couple deducted the losses.
The IRS challenged the losses, saying they are “passive” under the tax law. The taxpayers failed to convince the Tax Court that they spent enough time in farm activity to deduct the losses. From the Tax Court opinion:

Petitioners claim that in each of 2005 and 2006, whether at the ranch in Colorado or from petitioners’ home in Minnesota, Mr. Iversen spent a total of at least 400 hours working on matters relating to Stirrup Ranch, Mrs. Iversen spent at least another 100 to 150 hours working on matters relating to the horses at the ranch, and that they together meet the 500-hour test of section 1.469-5T(a)(1), Temporary Income Tax Regs.

Our analysis of the time and activity petitioners spent in 2005 and 2006 working on matters relating to Stirrup Ranch is made difficult by the lack of meaningful contemporaneous or other records and documentation regarding specifically what petitioners did on a day-to-day basis and how much time they spent on matters relating to Stirrup Ranch. In this case, the lack of records and documentation are not cured by estimates made years after the fact in writing or by testimony.

It’s up to the taxpayers to prove that they spent enough time on an activity for it to be non-passive. The taxpayers didn’t produce enough time sheets or other records to convince the judge.
The passive loss rules could take on much more importance if the “Affordable Healthcare Act,” or “Obamacare,” remains on the books. The law imposes a 3.8% additional tax on “passive” income starting in 2014. Obamacare defines “passive” using the passive loss rules. At a D.C. bar luncheon yestreday, practitioners noted that this could be a big problem for S corporations ($link)

Unless S corporations begin planning for the tax, shareholders “will be short” when it comes time to pay their taxes, especially those who have passive positions in those passthroughs, he said.
Coupled with a potential increase of the income tax back to 39.6 percent for the highest bracket, the Medicare contribution tax could pose significant problems for S corporations, which must maintain a single class of stock requirement, [Brian] O’Connor said. As a result, the S corporations must “distribute the same amount to everyone,” he said, adding, “So that essentially means that more money is going to be coming out of the company.”
If the income tax rates do rise to pre-Bush era levels, the effect will be “dramatic,” O’Connor said.

The moral? Entrepreneurs with loss activities are wise to keep track of their time daily. Absent AHCA repeal, all entrepreneurs will need to become time trackers.
Cite: Iversen, T.C. Memo 2012-19

(more…)

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It’s hard to be a real estate professional

Friday, January 13th, 2012 by Joe Kristan

It’s been a rough run in recent years for folks in the real estate game, for non-tax reasons. The tax law doesn’t make it easy to be a real estate professional either, as a Pennsylvania man learned yesterday from the Tax Court.
The tax law’s “passive loss” rules only allow you to deduct “passive” losses to the extent of passive income, except when you dispose of the activity in a taxable sale. For most taxpayers, rental real estate losses are automatically passive under the tax law. For non-real estate activities, the tax law determines whether you are passive based on the extent of your participation in the business.
“Real estate professionals” have a special deal. Their real estate losses aren’t automatically passive; they are instead tested under the usual “material participation” standards. That makes everyone want to be a real estate pro, at least on their tax returns. Unfortunately the tax law doesn’t make it easy to be a real estate pro. To qualify, you have to:
- Spend at least 750 hours per year participating in a real estate trade or business that you own, and
- You have to spend more time on real estate activities than other activities.

The second requirement makes it very difficult for anybody with a full-time non-real estate job to be a real estate pro under the tax law. It was too high a bar for Mr. Vandergrift from Pennsylvania (citations omitted; my emphasis):

Petitioners maintain Mr. Vandegrift qualifies as such an individual. He testified that over one-half of the total time he spent in business activity was devoted to the real estate business. We found Mr. Vandegrift to be generally honest and forthright, but his time estimate is suspect given his employment as a salesman for an employer in a business unrelated to the real estate activity. His subjective estimate also suffers from a lack of contemporaneous verification by records or other evidence.

We have held that the regulations do not allow a postevent “ballpark guesstimate” of time committed to participation in a rental activity. We are forced to find on the record before us that petitioners have failed to carry their burden of establishing that Mr. Vandegrift spent over one-half his work time in the real estate business.

The only case I’ve seen where a taxpayer with a full-time day job qualified as a real estate professional had two unusual facts: A cushy day job that didn’t require a lot of time, and a taxpayer who kept meticulous time records. Absent those facts, someone with a non-real estate day job is probably not going to qualify as a real estate pro under the passive loss rules.
Cite: Vandegrift, T.C. Memo. 2012-14

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It’s a long way from Milan, Minnesota to Nuremberg

Tuesday, December 20th, 2011 by Joe Kristan

A Minnesota banker-attorney has explored an unorthodox approach to tax : invoking the Nuremberg laws. Tax Court judge Holmes explains:

Erik Thompson didn’t file returns for tax years 2004 and 2006 because he disapproved of the wars in Iraq and Afghanistan and didn’t want to fuel “the government’s killing machine.” The Commissioner sent him a notice of deficiency, and Thompson filed a petition. He didn’t approach pretrial preparation in the spirit of cooperation that our Rules hope to inspire, because he saw “little distinction between the activities of the IRS and Tax Court and the activities of those good law-abiding Germans who drove the trains to the death camps.”

The IRS wasn’t persuaded by the analogy, and perhaps the taxpayer wasn’t either, as he began to change his approach:

He began to back off from such sentiments at trial and brought with him numerous documents that he’d never shared with the Commissioner. We reserved decision on the Commissioner’s motion to exclude this evidence, and Thompson eventually collaborated with the Commissioner to settle many issues. Two remain for both years in issue: (1) investment-interest expense and (2) rental-real-estate loss. The Commissioner says Thompson didn’t substantiate the former and didn’t participate actively enough in the rental real-estate activity to get the latter.

The IRS didn’t raise the issue of whether the losses were passive until trial, which led the banker-attorney taxpayer to protest that the IRS failed to raise the issue on a timely basis. The judge found that the IRS had some good reasons:

The Commissioner argues that “petitioner was not able to establish that the rental activity was non-passive or that the activity was engaged in for a profit.” Showing unusual chutzpah, Thompson blames the Commissioner for waiting too long to raise the issue of character of the losses. (At trial Thompson focused on the amount of the loss.)
It’s true that if an issue is untimely raised — unfairly surprising the opposing party by not giving him a chance to adequately address it at trial — we’ll refuse to consider it. Rolfs v. Commissioner, 135 T.C. 471, 484 (2010) (citing prior caselaw). But we disagree with Thompson’s premise. The Commissioner didn’t raise this issue for the first time on brief; he raised it at trial. (And considering Thompson hadn’t bothered giving the Commissioner anything relating to his deductions and losses until one week before trial, this was no small feat.)

The only way for the losses to be non-passive would be either:
- if the taxpayer met the “active participation” rule that allows up to $25,000 of rental losses to be deducted, a provision that phases out as AGI exceeds $100,000; or
- If the taxpayer met the “rental real estate professional tests (750 real estate hours and more than any non-real estate activities) AND materially participated in the real estate activity under the usual material participation tests.
Judge Holmes found he failed to meet the tests. Apparently the taxpayer brought his banking into the argument:

Thompson also makes “fairness” arguments concerning the Prairie losses. First he argues that because he believes Milan Agency, Inc., and Prairie [the rental business] are grouped together under banking law, they should be grouped together for tax law (and thus, we suppose, gains and losses of the two should be netted). But grouping for tax law — at least for the purpose of applying the passive-activity loss rules — is defined under section 1.469-4, Income Tax Regs., which doesn’t cross-reference banking law.

Fairness, of course, has nothing to do with the passive loss rules.
Cite: Thompson, T.C. Memo. 2011-291

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Rental home deduction disaster

Tuesday, October 18th, 2011 by Joe Kristan

When a school assistant principal took a new job in Minnesota, she held on to her house outside Kansas City and tried to lease it. Her tale as told in Tax Court yesterday provides lots of lessons in deducting rental losses.
Because she had adjusted gross income under $150,000′ she didn’t have to pass the difficult test of being a “real estate professional” to deduct her losses. She had to meet the much lower “active participation” test. The judge said she did:

The active participation standard can be satisfied without regular, continuous, and substantial involvement in an activity; the standard is satisfied if the taxpayer participates in a significant and bona fide sense in making management decisions (such as approving new tenants, deciding on rental terms, approving capital expenditures) or arranging for others to provide services such as repairs. Madler v. Commissioner, T.C. Memo. 1998-112.
In the instant case, it is clear that petitioner owns the Kansas City house and that she is the one who is not only responsible for making all management decisions but who in fact makes such decisions. We therefore find that petitioner satisfied the active participation standard in 2006 and 2007 and is therefore entitled to offset her nonpassive income for 2006 and 2007 by her substantiated rental losses, subject to the phaseout limitation (potentially applicable only in 2007).

The judge stressed the substantiation requirement for a reason. The court found that the taxpayer kept less than meticulous records, using excuses that she might have heard from wayward children in her school:

In the instant case, the documentary evidence regarding the disputed deductions is relatively scant. At trial, petitioner testified that she kept her tax records in the basement of her home in Minnesota and that the basement was flooded on three separate occasions, once when a sump pump failed, once when her hot water tank failed, and once after “a big storm”, which “soaked” certain of her records, prompting her to throw them out. However, it remains unclear why petitioner could not have reconstructed at least some of her records by contacting third-party payees, such as insurance and utility companies. Indeed, at trial, petitioner did not testify that she made serious attempts to do so.

The judge estimated some of the unsubstantiated deductions under the “Cohan Rule’” but the travel expenses for trips to the home failed the strict travel substantiation rules and were fully disallowed. The court allowed about $13,000 of the $25,000 deductions claimed and imposed a 20% penalty on the taxes owed.
The moral? Keep good records, and watch out for high water.
Cite: Bonds, T.C Summ. Op. 2011-122

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Tax Court: no matter how bald you are, your head isn’t real estate

Wednesday, October 12th, 2011 by Joe Kristan

There’s a superficial similarity between real estate management and barbering. Real estate managers have to keep the grass trimmed, and barbers have to keep the hair trimmed. That similarity didn’t help a California barber get his real estate deductions in Tax Court yesterday.
The “passive loss” rules only allow you to deduct “passive” losses to the extent of “passive” income. For most businesses, you are “passive” unless work enough in the business to “materially participate.” Real estate rental losses are a special case. For most taxpayers, they are automatically passive. If you are a “real estate professional,” however, then you can be non-passive if you “materially participate,” like in any other business.
The tax law makes it hard to be a real estate pro. You have to pass two tests:
- You have to work more than 750 hours in real estate trades or businesses, and
- You have to work more in those businesses than you do in any other business.
The second test makes it hard for those with day jobs to qualify. The barber, a Mr. Ani, failed to convince the Tax Court that he passed that test. From the opinion:

With respect to the two documents Mr. Ani’s accountant prepared, the first document was prepared as a sampling of the types of activities that could take place but was not complete enough to establish hours for each activity. The second document provided sufficient detail with respect to hours spent on the barber and real estate activities when coupled with Mr. Ani’s testimony. According to the second document, Mr. Ani spent a total of 1,377 hours performing barber services and 956 hours managing petitioners’ rental properties in 2005, and 1,380 hours performing barber services and 886 hours managing petitioners’ rental properties in 2006. Thus, Mr. Ani spent more time in 2005 and 2006 working as a barber than he did managing petitioners’ rental properties.

Decision for IRS.
While it is difficult for somebody with a non-real estate day job to qualify as a real estate pro, it has been done.
Cite: Ani, T.C. Summ. Op. 2011-119
To learn what “material participation means, read more.

(more…)

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Did the Tax Court just abandon the ’750 hours for every rental activity’ test?

Monday, September 12th, 2011 by Joe Kristan

Last year a Tax Court decision implied an additional hurdle for taxpayers wanting to claim that they “materially participate” in an activity. A decision last week appears to have quietly removed this hurdle.
Net rental losses are normally “passive” unless you qualify as a “real estate professional.” Passive losses are deductible only to the extent of passive income. If you qualify as a real estate pro, then you can deduct rental losses if you “materially participate” in your real estate activities under the same participation tests that apply to other activities.
To be a real estate pro, you have to pass two tests:
- You have to participate more than 750 hours in a real estate trade or business, and
- Your real estate activities have to take more time than anything else you do.
A 2010 Tax Court decision said there was an additional test:

Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.

At the time I argued that the last sentence was wrong — that the 750 hour test does not apply separately to each rental activity absent the “aggregation election.” A decision last week may indicate that the court has seen the light on this issue.
Last week’s case (discussed here) involved a taxpayer who had a day job that wasn’t in real estate, but that left him enough free time to do a lot of real estate work on his own properties. The Tax Court found that he was a qualifying real estate pro:

On the basis of the record and testimony provided at trial, we find that Mr. Miller has established that he spent more than 750 hours performing significant construction work as a contractor and on his rental real estate activities. We find that Mr. Miller spent more time on his construction work and rental properties than he did piloting vessels in the years at issue.

Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B)

.
The judge noted that Mr. Miller had not elected to “aggregate” his properties. Nowhere in the analysis of whether the taxpayer qualified does the judge consider whether he had to work 750 hours in each property to be able to count the rental hours towards the 750-hour minimum; in fact, he found that none of the properties reached the 750 hour requirements on their own.
I think that means the Tax Court has come around to my view. Sure, it would be nice if they would cite the Tax Update Blog in their decision (ahem!), but as long as they get the law right, that’s what matters.
Cite: Miller, T.C. Memo. 2011-219

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Real estate tax tip: have a cushy day job

Friday, September 9th, 2011 by Joe Kristan

If you have a day job that’s not in the real estate business, it’s hard to qualify for the “real estate professional” loophole in the “passive loss” rules. The tax law treats losses from rental real estate activity as automatically “passive” if you don’t qualify, and those losses are only deductible if you have “passive” income. If you are a real estate pro, you can deduct real estate losses if you meet the passive loss “material participation” rules that apply to all taxpayers for non-real estate losses.
To qualify as a real estate pro, you have to pass two tests:
- You have to spend at least 750 hours on your real estate activity, and
- You have to spend more time in your real estate business than you do on any other job you have.
The second test is usually impossible to pass if you have a non-real estate day job. But it can happen, as the Tax Court showed yesterday. The taxpayer husband, Mr. Miller, had a day job as a harbor pilot in San Francisco. He also had rental real estate property that Mrs. Miller helped him operate. Fortunately, piloting, while a skilled profession, seems to not be all that time-consuming:

At the age of 29, Mr. Miller became a partner in the San Francisco Bar Pilots Association (SFBPA) and began piloting commercial seagoing vessels for SFBPA.4 During the years at issue, Mr. Miller piloted client vessels for the SFBPA, including large container ships, passenger cruise ships and large military ships. He piloted these client vessels from 13 miles at sea, outside the San Francisco Bay Channel, throughout the San Francisco, San Pablo and Suisun Bays, including the Sacramento and San Joaquin Rivers.
Mr. Miller’s schedule as an SFBPA pilot requires that he work seven days and then have seven days off. Mr. Miller generally is not required to actually work for all of his seven days “on.” His schedule is also somewhat flexible and predictable. SFBPA pilots know roughly when they will have to work during their “on” time and can trade turns in the pilot rotation, subject to limitations.

That enabled him to throw himself into his real estate projects, and throw himself he did:

In addition to Mr. Bogart, other witnesses described Mr. Miller’s work ethic as extraordinary. A friend, pilot and partner of Mr. Miller’s at SFBPA testified to his “one in a million” work ethic, saying that he did not know anyone who worked harder. Mrs. Miller testified that she had to go to Mr. Miller’s construction sites to see her husband.

Wisely, Mr. Miller maintained records of his time, and he convinced the Tax Court that he met both the 750-hour and more-than-other-job requirements:

Mr. Miller completed a number of significant construction projects, both as a contractor and as a landlord, in the years at issue. He also performed a number of additional real estate tasks including researching properties, bidding on properties, finding tenants, collecting rent and performing maintenance work at rental properties. Mr. Miller presented contemporaneous work logs for his construction and rental activities and provided compelling testimony and witnesses. Thus, we find that Mr. Miller is a qualified real estate professional within the meaning of section 469(c)(7)(B).

But being a real estate pro is only the first step. Mr. Miller had to prove he “materially participated” in the loss activities. Mr. Miller passed that test for two of the activities, but not for four others:

Bennett Valley property for over 100 hours per year for the relevant years.10 We are also satisfied that their participation was not less than the participation of any other individual for those years. It follows, and we hold, that petitioners materially participated in the rental real estate activities at the Pepper Road property and the Bennett Valley property in the relevant years and the deductions attributable to those activities are not subject to limitation under section 469.
Petitioners have not shown, however, that they participated in the rental real estate activities at the Morning Glory property, the Lind property, the Price property or the Emerald property for over 100 hours per year for the relevant years.

The Moral: If you’re day job isn’t in real estate brokerage or development, you need a day job that isn’t very time consuming to qualify as a real estate professional. Then you have to work your butt off on your real estate work, and keep good records of your time.
Cite: Miller, T.C. Memo. 2011-219
Related: Being a ‘real estate professional’ only opens the door; it doesn’t carry you inside

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Farm Buildings and 100% bonus depreciation

Friday, August 12th, 2011 by Joe Kristan

Paul Neiffer summarizes:

If a farmer is constructing a new building and the construction commenced after September 8, 2010 and is finished before January 1, 2012, then the total cost is allowed to be 100% depreciated during 2011. If the building construction commenced before September 9, 2010 and was finished in 2011, then only 50% bonus depreciation is allowed (unless you can segregate out some components that can be 100% bonus depreciated this year).

This only applies to farm buildings. Non-farm residential or commercial real estate is not eligible for bonus depreciation, with a very limited exception for some restaurant buildings. If the bonus depreciation generates a loss, the usual rules limiting losses may apply — basis limitations, at-risk rules, and the passive activity loss rules.

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More on grouping passive losses

Tuesday, May 31st, 2011 by Joe Kristan

The IRS last week issued guidance on electing to treat all rental real estate activities as a single activity. Roger McEowen provides a roundup on grouping elections for all passive activities, including non-rental activities.

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…7,6,5… Got S corporation basis?

Monday, December 27th, 2010 by Joe Kristan

As we count down tax tips to year-end, we need to address the S corporation basis problem.
As longtime readers know, S corporations are normally not taxed on their income; the income is divided among its owners, who report the income or loss of the corporation on their own tax returns. If the corporation has a loss, the shareholder may be able to deduct it — but only if there is “basis” to do so.
An S corporation can get basis for deducting losses by having basis either in stock of the corporation or in loans made by the shareholder to the corporation. Guarantees of corporation third-party debt don’t count.
Your basis in S corporation stock is the amount you paid for the stock, increased by capital contributions and earnings, and decreased by distributions and losses. Basis in S corporation debt starts with the amount loaned; it is reduced by losses in excess of the basis of corporation stock, and restored by undistributed S corporation income.
With 100% bonus depreciation available for assets purchased after September 8 and placed in service before year-end, many taxpayers find themselves with unexpected tax losses in their S corporations. If they don’t have basis to deduct their losses, they may be in for a nasty surprise on April 15. Any S corporation owner who is counting on deducting losses needs to double-check her tax basis. If basis is short, some thoughts to get those losses:
- Contribute to the capital of the S corporation. This is the easiest way to go, but it can be troublesome if there are other owners who don’t want to be diluted.
- Loan money from personal funds to the S corporation. That can enable you to deduct the losses without diluting other owners. There’s a catch, though: if the loan is repaid before the S corporation has earned back the losses, the repayment will trigger taxable income.
- Borrow money from a third-party and then loan the borrowed funds to the S corporation. These “back-to-back” loans can be effective if you borrow from an unrelated party; they can be disastrous if you borrow from somebody with an interest in the S corporation’s business.
- If you own multiple S corporations, consider combining them in an S corporation holding company. This puts all of your basis in one place, allowing you to use basis from profitable companies to offset losses from others. This is definitely a tool that requires tax pro involvement.
Don’t play basis-around-the-rosey. It’s dangerous borrow from one of your S corporations and loan the funds to another S corporation – especially if the funds end up back in the S corporation where they started. If you have to use funds from one S corporation to get basis in another, take a distribution from the first corporation, rather than a loan, and don’t put the money back where it started.
And remember — it’s not enough to have basis to deduct S corporation losses. The basis has to be “at-risk” and the losses have to be “non-passive.”
We’re counting down to year-end with a new tax tip each day. More tomorrow!

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Being a ‘real estate professional’ only opens the door; it doesn’t carry you inside

Tuesday, October 26th, 2010 by Joe Kristan

Real estate rental losses are by law “passive” to most taxpayers. That means they can only deduct the losses to the extent they have other “passive” income, or upon a sale. Taxpayers with AGI under $125,000 who “actively participate” in their rental activity may also deduct up to $25,000 in losses.
A special rule makes it easier for “real estate professionals” to deduct rental losses. If you qualify, real estate losses are non-passive if you meet the “material participation” tests that apply under the passive loss rules to non-real estate activities. But this rule doesn’t automatically make the losses deductible for real estate pros, as a California “real estate loan agent and broker” learned in Tax Court yesterday.
You can be a qualifying real estate professional if you pass two tests:
1. You spend at least 750 hours per year in real estate trades or business that you own, and
2. You spend more time in real estate businesses than in any other activities.
The judge explains the taxpayer argument:

Petitioner argues that because she is a qualifying real estate professional pursuant to section 469(c)(7)(B), all her real estate activities, including rental activities, are not passive and therefore she is not subject to the passive activity loss limitations.

Caselaw clearly requires that a taxpayer claiming deductions for rental real estate losses meet the “material participation” requirements of section 1.469-5T, Temporary Income Tax Regs., supra, even where the Commissioner has conceded that the taxpayer is a real estate professional pursuant to section 469(c)(7)(B).

The special rule for real estate pros just allows them to deduct rental loss if they “materially participate” in the real estate activity. Their losses are no longer automatically passive, but they do not become automatically deductible.
Cite: Perez, T.C. Memo 2010-232.
Related: Why I think the Tax Court judge got the passive loss 750-hour test wrong

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Rental real estate: those don’t also serve who only stand and wait

Tuesday, September 21st, 2010 by Joe Kristan

The tax law “passive loss” rules limit “passive loss” deductions to the amount of “passive” income earned in a tax year, except when a “passive activity” is disposed of in a taxable sale. A special rule makes it worse for owners of rental real estate, which is always “passive” unless you qualify as a “real estate professional.” If you do qualify, then you can avoid the passive loss limits if you “materially participate” in the activity — a test based on how much time you spend on the activity.
The tax law says you have to meet two requirements to be a real estate pro:
- You have to spend at least 750 hours working in real estate trades or businesses, and
- You have to spend more time working in real estate than on any other activities.
A nuclear plant operator in New Jersey operated several rental properties on the side. The properties showed a loss on his joint 2007 return of $40,490, which he deducted in full as a real estate professional. The IRS looked at the return and disallowed the deduction attributable to his being a real estate professional (part of the loss was allowed anyway under a provision that allows some taxpayers with incomes under $150,000 to deduct part of a passive real estate loss) and asserted negligence penalties.
The taxpayer, a Mr. Moss, could only come up with 645.5 hours of work spent on the properties in 2007. But he could have worked more because he was “on call” in case something went wrong, as the Tax Court explained:

Essentially, petitioners claim that Mr. Moss could have been called to perform work at the rental properties at any time that he was not working at the Hope Creek plant, and, therefore, such on call hours should count toward meeting the 750-hour service performance requirement. We do not agree with petitioners’ contention that Mr. Moss’ “on call” hours may be used to satisfy the 750-hour service performance requirement. Section 469(c)(7) applies where the taxpayer “performs more than 750 hours of services”. Sec. 469(c)(7)(B)(ii) (emphasis added); see also sec. 1.469-9(b)(4), Income Tax Regs. (“Personal services means any work performed by an individual in connection with a trade or business” (emphasis added)). While Mr. Moss was “on call” for the rental properties, he could have been called in to perform services; however, these services were never actually performed by him. Accordingly, we conclude that Mr. Moss’ time “on call” for the rental properties does not satisfy any part of the 750-hour service performance requirement.

The court upheld the disallowance and the penalties.
The Moral? Coulda, woulda doesn’t get you far in Tax Court.
Cite: Moss, 135 T.C. No. 18
Related: Why I think the Tax Court judge got the passive loss 750-hour test wrong
Below: material participation basics.

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Why I think the Tax Court judge got the passive loss 750-hour test wrong

Saturday, August 28th, 2010 by Joe Kristan

Last week I questioned whether a Tax Court judge was correct when he commented that absent an election to combine rental real estate activities under Sec. 469(c)(7), each real estate activity has to meet the “750 hour test” to make a taxpayer a “real estate professional.” This often would make a taxpayer’s status as passive or non-passive hinge on a procedural foot-fault — the filing of the Sec. 469(c)(7) election.
If a taxpayer becomes such a “qualified taxpayer,” then rental real-estate losses can be non-passive, and therefore deductible even absent offsetting “passive” income.
An alert reader poses this question to me:

Re the 750 hour test, Reg.

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Why it’s tough to have “non-passive” real estate activities

Tuesday, August 17th, 2010 by Joe Kristan

The passive loss rules enacted in 1986 aimed right at the real estate business. The rules, which disallow “passive” losses until they can be offset by “passive” income, generally treat rental real estate as “passive” no matter what.
There is a narrow exception for “materially-participating real estate professionals.” These taxpayers can determine whether their real estate rental is “non-passive” based on the usual rules for passive losses, which depend on how much time you spend on the activity. For example, your “materially participate” in an activity if you spend 500 or more hours on the activity in a year, or if you spend more than 500 hours on multiple activities that you spend 100-500 hours on each.
But first you have to be a “materially-participating real estate professional.” To qualify you have to meet two requirements under Sec. 469(c)(7):
- You have to work more than 750 hours in a “real property trade or business,” and
- your real property trade or business hours have to exceed your working time in non-qualifying businesses.
A Tax Court decision issued yesterday illustrated how hard it can be to clear this hurdle. A woman who worked as an office manager for a real estate broker (she wasn’t an owner) also owned and managed three rental properties with her husband. She claimed the rental property losses as non-passive.
The Tax Court pointed out an important limit on the real estate professional rule: it doesn’t count service “as an employee.” If you don’t own at least five percent of the business that gets you to your 750 hours, those hours don’t count. The court quoted IRS Publication 925:

Do not count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. You were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer’s outstanding stock, outstanding voting stock, or capital or profits interest.

That meant the taxpayer, a Mrs. Bahas, had to meet the 750-hour test with just the rental properties. As the taxpayer stipulated that the time spent on the rental properties was less than 750 hours, she failed this test.
As an aside, the court made an assertion about the 750 test that strikes me as incorrect. The tax law allows qualifying real estate professionals to elect to “aggregate” their activities so they can combine their working hours for the material participation tests. The Court drew this conclusion:

Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties.

Sec. 469(c)(7)(B) has the 750-hour requirement:

(B) Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if

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IRS defies courts on trust passive losses

Tuesday, July 27th, 2010 by Joe Kristan

Roger McEowen:

When a government agency is told that its litigating position has

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How many ways can’t you deduct your vacation cabin?

Thursday, April 22nd, 2010 by Joe Kristan

Once you decide to buy that vacation cabin, you’re committed. If you vacation anywhere else, you feel like you’re squandering your investment. Yet you can’t spend all of your time there, and it would sure be nice if you could get some tenants while you’re not there. It’s even nicer if the IRS can help you pay for it.
20100422-1
Flickr image courtesy Let Ideas Compete under Creative Commons license
And yes, there are tax breaks for second homes. The biggest one is the home mortgage interest deduction, available for up to two homes. You can also deduct property taxes, at least if you aren’t subject to alternative minimum taxes. But what about the home itself, and your out-of-pocket costs? Can you claim the cabin as a rental property, deduct depreciation, insurance, and maintenance, and move your property taxes to an “above-the-line” schedule E deduction?
Probably not. It didn’t work for a California man with a 3-bedroom cabin. The man deducted $20,258 as Schedule E losses in 2004. The Tax Court sets the stage:

Petitioner contracted with Alpine Resort Rentals (Alpine), a property management company, to rent the cabin for the 2004 tax year. Per the rental agreement, Alpine had an exclusive right to rent the cabin during 2004. For its services, petitioner paid Alpine a 35 percent commission of all rental income received. Among other things, Alpine was responsible for arranging housekeeping and linens for rental customers; petitioner was responsible for maintaining the property in a safe and aesthetic condition, paying all utilities, having the property “deep cleaned” twice a year, and providing linens.
The cabin was rented 3 times during the 2004 tax year, for a total rental period of 12 days and 9 nights. The parties have agreed that the average rental period of customer use for the cabin for 2004 tax year was 3 days.
Petitioner visited the cabin eight times during 2004, for a total of approximately 27 days and 19 nights. Each time petitioner visited the cabin during 2004, he was accompanied by family members.

The IRS attacked the loss on two fronts. First it went after the loss under the “passive loss” rules. Normal rental real estate losses are subject to a “per-se” passive loss limit, unless you are a real estate professional. Our Californian tried to take advantage of a special rule that allows taxpayers with adjusted gross income under $150,000 to deduct rental real estate losses when they “actively participate” in the rental activity. The IRS countered:

An activity involving the use of tangible property, however, is not considered a rental activity for a taxable year if for such taxable year the average period of customer use for such property is 7 days or less. Sec. 1.469-1T(e)(3)(i) and (ii)(A), Temporary Income Tax Regs., supra. Therefore, owners of rental real estate are not considered to be engaged in a rental activity if the average period of customer use is 7 days or less.

Failing that, the taxpayer argued that if it wasn’t a “per-se” passive activity, he wasn’t “passive” and could deduct the losses under one of two rules: either he did “substatially all” of the work involved in the property, or he spent at least 100 hours and more than anyone else. The Tax Court said this failed too (my emphasis):

To satisfy one of these tests, petitioner must establish that either (1) no other individual’s participation exceeded petitioner’s participation during 2004 or (2) that petitioner participated in the activity for more than 100 hours in 2004. With regard to the second requirement, petitioner has set forth little evidence to establish that he was involved in the rental of the cabin for more than 100 hours in the 2004 tax year. He has alleged that he took eight maintenance trips to the cabin during 2004, but in no way has he quantified for the Court the amount of his active participation time. In order to establish that he did spend more than 100 hours engaged in the rental of the cabin, the Court would expect petitioner to provide evidence corroborating his claim that his trips to the cabin were indeed for the purpose of maintenance, e.g., in the form of time logs, oral testimony, and/or receipts.
Nor has petitioner established that no other individual’s participation exceeded his participation in the activity or that his participation constituted substantially all the participation in the activity. Alpine was responsible for advertising, showing, and renting the property, and after each tenant, a cleaning service cleaned the property. Further, petitioner has conceded that his daughter assisted in the management and maintenance of the cabin and that he contracted with professionals to provide repair services during 2004. While we do not know how much time these services took, they involve a substantial amount of time.

It’s up to you to prove your participation, and the Court found the taxpayer failed to do so.
The other IRS line of attack on vacation home deductions is Sec. 280A, which limits operating deductions for vacation homes to rental income if the cabin is used personally for the greater of 14 days or 10 percent of the day is is rented. Maintenance trips don’t count as personal use, but again it is up to the taxpayer to prove that a trip is a maintenance trip:

Petitioner has presented no evidence to substantiate his contention. He has not provided to the Court any receipts, work reports, time logs, or testimony to support his claim that the motive of his trips and his activity at the cabin was in fact for upkeep. Although cautioned at trial that his opening statement was not evidence that the Court could rely on to make findings of fact, petitioner chose not to testify at the trial, relying entirely on the stipulation of facts and the stipulated exhibits to provide all of the evidence in his case. Hence, petitioner has failed to meet his burden of proving that personal use of the cabin did not exceed the greater of 14 days. Consequently, the cabin is considered a residence for purposes of section 280A.

The taxpayer didn’t lose all of his tax breaks. Because he rented the house for less than 15 days in 2004, he was allowed to exclude the rent received from taxable income. He also was allowed itemized deductions for his mortgage interest and property taxes. But the rest of the deductions — depreciation, repairs and so on — were lost.
The Moral? If you want to take deductions for your vacation home above the line, you need to keep records of how much time you spend there, and how you spend it. If you can’t prove your participation, the tax law won’t help you.
Cite: Akers, T.C. Memo 2010-85
Related: NON-PASSIVE RENTAL LOSSES: NO FUN WITH DICK AND JANE

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