Below-Market Rent Makes Rental Losses Nondeductible – A Physician’s Tale

December 28, 2015

Individual taxpayers can claim itemized deductions for qualified residence interest on up to two personal residences (the principal residence and one more) and for real property taxes on as many personal residences as they own [IRC Secs.163(h)(3) and 164(a)(1)]. Other expenses attributable to personal residences are generally treated as nondeductible (with exceptions for casualty losses and for personal residences that are partly used for business or rental purposes).

In contrast, when the residence is rented out for the year, the taxpayer can deduct many more expenses on Schedule E. They can also deduct net losses from such properties, subject to the Section 469 Passive Activity Loss (PAL) rules. Here’s the rub. If you rent out a property to a relative, the property falls under the less-favorable federal income tax rules for personal residences-unless you meet certain guidelines. In a recent Tax Court decision, the taxpayers learned this lesson the hard way [Okonkwo, TC Memo 2015-181 (Tax Ct. 2015)]. We will give you the story on that decision after first covering some necessary background information.

Tax Basics on Renting to Relatives

In general, a taxpayer cannot claim deductions for a dwelling unit that is classified as a personal residence [IRC Sec. 280A(a)]. As stated earlier, there are important exceptions to this general rule (e.g., qualified residence interest, property taxes, and casualty losses), but the exceptions are limited.

Under IRC Sec. 280A(b), expenses allocable to the rental use of a personal residence that could be deducted in any event (e.g., allocable qualified residence interest and property taxes) can be deducted on Schedule E. Other expenses allocable to rental use (e.g., maintenance and repairs, property insurance premiums, utilities, HOA dues, security services, depreciation, and so forth) can only be deducted to the extent of rental income reduced by the expenses that can be deducted in any event [IRC Sec. 280A(c)(5)]. In other words, other expenses allocable to rental use can only be deducted to the point that rental income is fully offset. Put another way, such expenses cannot create or increase a Schedule E net loss from the property.

For federal income tax purposes, a dwelling unit is classified as a personal residence if it is used during the year for personal purposes for more than the greater of: (1) 14 days or (2) 10% of the number of days it is rented out at fair market rates. Personal use generally includes any use by the owner, any use by certain family members, and any use by any other party (family or otherwise) who pays less than fair market rental rates. For this purpose, family members only include the owner’s siblings, half-siblings, spouse, ancestors, and lineal descendants. [See IRC Sec. 280A(d)(1) and (2)(A).]

So, when a property is rented to a family member, it will generally fall under the less-favorable tax rules that apply to personal residences. The big exception to this general rule is when the property is rented out at fair market rates to a family member who uses the property as his or her principal residence [IRC Sec. 280A(d)(3)(A)]. When this type of use occurs, it is considered rental use rather than personal use, and the property is treated under the more-favorable tax rules that apply to rental properties. (This assumes the property is not used for personal purposes during the year for more than the greater of: (1) 14 days or (2) 10% of the number of days it is rented out at fair market rates.)

Facts Underlying the Recent Tax Court Decision

Charles Okonkwo was a Bel-Air, California cardiologist. He and his wife (together, the taxpayers) owned a house in Woodland Hills, California. The taxpayers built the house in 1997 with the intention of selling it. When they were unable to do so, they ceased trying to sell it and instead rented it out for $6,000 per month to an unrelated tenant from 2002 – 2006. From 2007 through March 2010, the taxpayers’ daughter resided in the house and paid rent of only $2,000 per month. During this time, the taxpayers resumed their efforts to sell the property. For 2009 and 2010 (the tax years in question with regard to the treatment of the Woodland Hills house), the taxpayers deducted (as business losses on Schedule C) expenses in excess of the rent paid by their daughter of $84,600 and $107,820, respectively. The taxpayers’ returns for those years were prepared by a tax professional, who was told that the significant drop in rental income was due to the previous tenant moving out and the daughter moving in.

After an audit, the IRS disallowed the taxpayers’ 2009 and 2010 net losses from the Woodland Hills house, apparently on the grounds that the losses were passive. Missed that boat! The IRS also imposed the 20% Section 6662 accuracy-related penalty. The taxpayers were unhappy because their tax professional told them their losses were fully deductible, so they took their case to the Tax Court.

What the Tax Court Concluded

The Tax Court correctly noted that the real issue here was whether the Woodland Hills house was in 2009 and 2010 a personal residence subject to the aforementioned Section 280A deduction limitation rules because the house was rented at below-market rates to the taxpayers’ daughter. The taxpayers claimed that they were real estate developers and that they rented the Woodland Hills house to their daughter only because their homeowners’ policy required that the house be occupied. In essence, the taxpayers claimed that this factor made Section 280A inapplicable.

The Tax Court did not buy that argument and concluded that the Section 280A rules did indeed apply. Therefore, the deductions allocable to the rental use of the Woodland Hills house were limited to the amount of rental income pursuant to IRC Sec. 280A(c)(5). However, the Tax Court let the taxpayers off the hook for the 20% Section 6662 penalty because they relied in good faith on an experienced tax professional’s advice that Section 280A did not apply to the Woodland Hills house and that their claimed deductions for that property were fully allowable.

The Bottom Line

Consider the Okonkwo case to be a cautionary tale – physicians with rental properties renting to a relative (as defined in Section 280A) will not produce the expected tax results unless the relative uses the property as his or her principal residence and pays fair market rent. It’s a good idea to obtain documentation that fair market rent was charged. An email from a realtor who handles rental properties in the area should suffice. Keep the proof in the your tax papers.

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