The Tax Code is built on a dichotomy between business and personal. That is one of the ideas that runs throughout each semester of my basic tax class. Whether a taxpayer is entitled to deduct an item of expense depends on whether the Code classifies the expense as business or personal. In one box go expenditures needed to carry on an activity engaged in for profit. Section 162 allows taxpayers to deduct the money it takes to make money. In another box go expenditures made for personal consumption. Section 262 disallows a deduction for such expenses. One finds the same dichotomy in §165, which permits taxpayers to deduct business losses, but not non-business losses.
Sometimes it is difficult to distinguish business from personal. In life, the difference is not a dichotomy but a continuum with expenditures often made for mixed purposes. Still, taxpayer activity falls into either the deductible box or the non-deductible box. There is no in-between. The expense (or loss) is deductible or it’s not. Congress helps taxpayers figure out into which box they fall with various statues. Treasury helps them with various regulations. And courts help with decisions like two Tax Court decisions from last week.
Last week the Tax Court issued two opinions that teach lessons about distinguishing business activity from personal activity. First, Carlos Langston and Pamela Langston v. Commissioner, T.C. Memo 2019-19 (Judge Nega) presents a really nice twist on the classic problem of how to tell when a taxpayer has converted a personal residence into an income-producing property. There, the taxpayer's actual rental was not sufficient to convert a property formerly used as a personal residence into a property held for the production of income. That surprised me. Second, Edward G. Kurdzeil, Jr. v. Commissioner, T.C. Memo 2019-20 (Judge Holmes) concerns whether a taxpayer’s very expensive plane restoration activity was a business or a hobby. I will blog Langston this week and Kurdziel next week.
The Tax Code treats ownership of property as being either for the production of income or else for personal consumption. We all know home ownership can be both. Many folks choose to buy a home rather than rent because, in part, they hope their home will appreciate and they can later sell for a profit. Notwithstanding that mixed motive, when a personal residence is sold for a loss, Treas. Reg. 1.165-9 makes explicit what is implied by §165: the loss is not deductible if the home was a personal residence at the time of sale. However, the regulation also provides that if a taxpayer moves out and the home is then “rented or otherwise appropriated to income-producing purposes and is used for such purposes up to the time of its sale,” then any loss becomes deductible.
I teach my students that renting out a former home is pretty much the gold standard to successfully convert it into an income-producing property. After reading Langston, I have to change my teaching! The line is not so bright.
In 1997 the Langstons bought a house in Tulsa on 75th Place, most likely this one. In 2001, when the home appraised for $290,000, they began remodeling the house. In 2005 they moved out of the house and into nearby apartments. The remodeling continued. At first the Langstons left lots of their stuff in the house because the apartments did not have sufficient storage. Over time---the opinions does not give specifics---they moved all their stuff out and, in 2008, they bought a second house and moved into it.
The remodeling was finished in 2010 but the house remained empty. In 2011 their insurance company told them that if the 75th Place house remained vacant, they would lose their homeowner’s coverage. To keep the insurance coverage, the Langstons found a friend who agreed to rent the house for 5 days per month for $500/month. In 2012 the Langstons put the 75th Place house on the market and they sold it in 2013 for $540,000. The cost of the remodeling, however, put their basis much higher and the sale produced a loss of over $400,000.
The Langstons deducted the $400,000 loss on the theory that they had converted the property into income-production when they rented it out in 2011. After all, that is when they began receiving actual real rent. Alternatively, they argued that they converted it to income-production because they were waiting to profit from the home’s appreciation over time.
Judge Nega was unimpressed with both arguments. First, if a rental is done right, it can show an intent to produce income from property. That is because by renting the taxpayer irrevocably abandons the property for personal use, at least for the duration of the lease, and the taxpayer is trying to extract profit from the fair rental value. Rumsey v. Commissioner, 82 F.2d 158 (2d Cir. 1936).
Judge Nega did not think the Langstons did it right. The facts that they did not put it on the market for rent and got a friend to rent is for only 5 days a month led him to find that they were only renting to preserve their homeowner’s insurance. He concluded the rental was “without profit motive.” I submit that to do it right they needed to abandon their homeowners insurance and secure a different insurance product, such as landlords insurance. They would need to actually market the property as a rental. And they would actually rent for more than a 5-days-a-month term.
As to the second argument, the Langstons’ attorney did a good job in trying to frame their decisions as an attempt to profit from the remodeling and resulting appreciation in value. The sales listing for the house claimed the remodeling cost $1.1 million. The main fact favoring this theory was that they had stopped using the property for personal living and storage by 2008, about four years before they sold the property. That gave them an argument that they were intending to profit from the appreciated value of the home. One might think this an especially strong argument in light of how the great recession trashed real estate values starting in 2008. So their baseline for making a profit was really a baseline for losing only their sleeves and not their entire shirt.
Judge Nega did not agree. When a taxpayer avoids renting property and claims to hold it only for its appreciation value, then “in order to be treated as holding the property for the production of income he must intend to realize gain representing post-conversion appreciation in the fair market value of the property.” Grant v. Commissioner, 84 T.C. 809, 825 (1985).
What troubled Judge Nega here was that the Langstons made no effort to market their property at any time before 2012. Wrote the Judge: “the Court finds that the move to the Yale Apartment was not motivated by petitioners’ testified desire to renovate and sell the home as an income-producing asset. Petitioners did not market the home for sale until 2012." These facts are in sharp contrast to cases where taxpayers have won on this theory, such as Smith v. Commissioner, T.C. Memo 1967-28 (home abandoned in 1961, immediately put on market, sold in 1964) and Lowry v. United States, 384 F. Supp. 257 (D. N.H. 1974)(abandoned in 1967, immediately offered for sale, sold in 1973).
Accordingly, it was the taxpayer's failure to commit that left Judge Nega unclear on “whether they intended to move back to the 75th Place property or whether the renovations had become a nearly-decade-long hobby."
Taxpayers (and their advisors) need to be clear as early as possible what they are intending to do. I still say the best way to establish conversion is to rent, but now I have learned from this case that taxpayers need to do it right. Rent to a real tenant for a real time period and a real amount of money. It looks like the Langstons simply were not sure about why they were remodeling. If they really were intending to flip the house when they moved out in 2005, or when they bought their new house in 2008, they either did not seek advice or else received unhelpful advice on how to establish their intent to flip. But it sure looks like they moved out to allow the remodeling to continue, then one thing led to another and they decided at some point they were not going to move back in. That is the point where they needed to establish the conversion. Renting to a friend for 5 days a month still looked too personal. Sure, there may be a continuum of motives, but the objective facts need to be enough so the Tax Code puts you in the doing-this-to-make-money box. They need to be such that you can credibly say "nothing personal."
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University (Sweet 16!) School of Law