Tax shelters come in many forms. Some shelters are activities that have no genuine economic purpose; they exist simply to generate tax benefits. Some micro-captive insurance arrangements are a great example, as you can learn from this wonderful brief by former tax officials filed recently in a Supreme Court case (I blogged about the case here). Other shelters are activities that allow taxpayers to deduct otherwise non-deductible personal expenses.
Today’s case involves that second kind of tax shelter. Taxpayers who own vacation properties can generate deductions for maintenance, utilities, and depreciation by renting out the properties even while also using the properties for personal pleasure. Thus, the rental activity can help ameliorate the personal costs of ownership by turning otherwise personal costs into rental costs. And if the rental costs exceed the rental income, why then taxpayers have a loss and many taxpayers will try to use that loss to shelter non-rental income.
In Ronald J. Lucero and Mary L. Lucero v. Commissioner, T.C. Memo. 2020-136 (Sept. 29, 2020) Judge Pugh teaches a great lesson about the limits of using beach houses as tax shelters. The taxpayers owned a beach house in Sea Ranch, California and rented it out. They had net losses. The Court did not allow them to deduct those losses to shelter non-rental income, even though their personal use was only about one week each year. It’s a nice lesson on how the restrictions on deductions in §280A and §469 work. Details below the fold.
Renting out a vacation home is one of those areas where pleasure mixes with business. Often taxpayers buy vacation properties so they can get away and relax. By mixing in a little rental activity taxpayers can ameliorate the personal costs of ownership, thus working around the disallowance of deductions for personal expenses found in §262.
This benefit is most obvious when rental income exceeds total costs of ownership. Then the taxpayer has succeeded in offsetting all ownership costs. The extra income gets taxed. When rental income is less than total costs of ownership, however, the income is still a tax-free way to offset a portion of those otherwise personal costs. The rental income is tax-free precisely because the costs offset by the income are deducted as ordinary and necessary expenses for the activity of holding the property for production of income. §212(2).
When rental income is less than total costs of ownership, taxpayers would love to deduct the resulting net loss against non-rental income. That would give the same result of wiping out the total costs of owning the vacation property.
Over the years Congress has restricted the ability of taxpayers to use net losses to shelter non-rental income, even while allowing taxpayers to deduct costs against rental income. Congress imposes these restrictions mainly through three sections: §183, §280A, and §469. Each section serves a broader purpose than just restricting losses on vacation properties, but as all touch on vacation home ownership, let me just sketch out a bit about each.
Law: §280A and §183
Congress enacted §280A in the Tax Reform Act of 1976, P.L. 94-455, 90 Stat. 1520, 1569.
Section 280A applies when a taxpayer uses a vacation home partly to produce rental income and partly for personal purposes. The basic restriction is that deductions associated with the rental activity may not exceed income from the rental activity. §280A(c)(5). Thus, the effect of §280A is to deny taxpayers the ability to use net losses against other income in the current year. However, §280A(c)(5)(flush language) permits the taxpayer to carryforward the unusable deductions into the next tax year and apply them, if possible, against the next year’s rental income.
Section 280A does not apply, however, if the rental activity is de minimis. Section 280A(g) draws the de minimis line at 14 days. That is, if you rent your property out for 14 days or less during the year §280A(g) says you may not take any deductions. And then it also says you also do not have to report the income. Seriously! Here’s a lovely tax exclusion---created for the benefit of those who live near Augusta Golf Course says this Forbes article---that is buried in a Tax Code section restricting deductions! Justice Scalia was obviously oblivious to this when he famously proclaimed that "Congress ... does not, one might say, hide elephants in mouseholes." Whitman v. American Trucking Association, 531 U.S. 457, 468 (2001). Well, he was not looking in the right mousehole.
Section 280A also does not apply if the personal use is de minimis. Section 280A(d)(1) says that a taxpayer can use rental property for personal purposes for at least 14 days and at most 10% of total rental days and that small amount of personal use will not trigger §280A’s restrictions on deductions.
Even if 280A does not apply because of de minimis personal use, however, the taxpayer needs to watch out for §183. That section works just like §280A in that it restricts deductions associated with an activity to the income from that activity. Unlike §280A, however, §183 does not permit the unused deductions to be carried forward. It just takes them away, period.
The §183 restrictions will potentially apply even if a vacation home rental is not covered by §280A. It will apply unless the taxpayer shows a genuine profit motive for the rental. Taxpayers get a presumption they are in it for the money if they make a profit in at least 3 of 5 years. The critical question, however, is whether making a profit was the taxpayer’s "predominant, primary, or principal objective" for engaging in the activity. See e.g. Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993). Section 183 is not at issue for today’s lesson. You can find a good illustration of §183 in Lesson From The Tax Court: Yachts Are Pigs, TaxProf Blog (July 1, 2019).
Here is how I summarize these points for my students:
Law: Section 469 Passive Activity Losses
Ten years after enacting §280A, Congress added §469 to the Code in the Tax Reform Act of 1986, Pub. L. 99–514, 100 Stat. 2085, 2233. The purpose was to attack the first kind of tax shelters, those that have no economic substance beyond generating tax benefits. See Joint Committee Staff, “General Explanation of Tax Reform Act of 1986” (a/k/a “Bluebook”)(May 4, 1986) at 209-215. But it reaches farther.
Section 469 does not restrict deductions the way §280A and §183 do. Those sections restrict the deduction of expenses such that the taxpayer cannot report a loss from an activity. Section 469 allows taxpayers to deduct expenses in excess of income. What it restricts is the ability to deduct the resulting loss. The restriction basically works this way: a taxpayer’s income-producing activities are classified into one of two types: “active” or “passive.” Losses may only be taken against the same type of activity. Passive activity losses (PALs) may only offset passive activity income and active activity income may only be offset against active activity losses. Unused PALs may be carried forward into the next year. §469(b).
Section 469 says that “material participation” makes an activity active. The idea here is that a “taxpayer who materially participated in an activity [is] more likely than a passive investor to approach the activity with a significant nontax economic profit motive, and to form a sound judgment as to whether the activity had genuine economic significance and value.” JCT Bluebook at p. 212.
While §469(c)(2) says “any rental activity” is passive per se, the regulations clarify that means long-term rentals. Short term rentals---where the average rental period is 7 days or less---are not automatically passive. Treas. Reg. 1.469-1T(e)(3). Accordingly, for most vacation home rentals, taxpayers need to understand the material participation standard...at least if they want to deduct net losses from the rental. The good news is that if such taxpayers do materially participate then they have unrestricted access to their loss deductions. The bad news is that since vacation home rentals will not usually be “rental activity” that means that taxpayers cannot qualify for the §469(i) $25,000 exception to the passive activity loss prohibition in §469(a).
The statutory definition of “material participation” in §469(h)(1) is unhelpfully vague. The regulations give much more structure, centered on number of hours of participation each year. The key numbers are 500 hours and 100 hours.
As applied to vacation rentals, if a taxpayer can show participation of more than 500 hours per year, that will be “material participation.” Treas. Reg. 1.469-5T(a)(1). If a taxpayer shows participation of 500 or less but over 100 hours, then that participation can qualify if the taxpayer also shows that no one else put in more hours (including any real estate management company employee). Treas. Reg. 1.469-5T(a)(3). Finally, if a taxpayer puts in 100 hours or less, then they're in twubble! But they can still meet the participation requirement if they show that their work “constitutes substantially all of the participation in such activity of all individuals” including anyone who helps them in the activity. Treas. Reg. 1.469-5T(a)(2). The regulations also contain other tests for material participation but those are not germane to today’s lesson.
As you might expect, all of this requires the taxpayers to prove up the hours of participation. Treas. Reg. 1.469-5T(f) gives the rules but the basic idea is that taxpayers must substantiate with adequate records, and contemporaneous records are the best.
Coordination between §469 and §280A: Section 469(j)(10) says that if both §469 and §280A apply to the use of property, then taxpayers should apply §280A first. That means, per §280A(c)(5), that there will simply not be a loss for §469(a) to restrict. Instead the taxpayer will have to carry the unused deductions (the ones that exceed expenses) into the next year.
The tax years at issue are 2014 and 2015. Mr. Lucero owned a beach house in Sea Ranch, California, an historic private development taking up about 10 miles of the coast in northern Sonoma County. Wikipedia says about half of the houses are rented out as vacation homes.
In 2014 Mr. Lucero filed an individual return reporting 146 rental days, rental income of some $26,200, expenses of some $44,800, for a net loss of some $17,500. In 2015 Mr. and Ms. Lucero filed a joint return reporting 152 rental days, income of about $26,700, expenses of about $51,200, for a net loss of about $24,500. The rental periods averaged less than 7 days.
During the years at issue Mr. and Ms. Lucero lived in Sacramento, some 3-4 hours away. They employed a property management company to manage the property, including advertising, dealing with tenants, and maintaining the property during the year. Each year, the Luceros spent about a week at the beach house enjoying the winter holidays with family. They also traveled to the beach house six to eight other times a year where, they testified, they did landscaping, cleaning, repairing, and inventory on the property. Those would not be personal use days for §280A purposes. §280A(d)(2).
In both years the taxpayers attempted to deduct the losses against other income. The IRS disallowed the loss deductions because, it said, the losses were from a passive activity and so could not be deducted against the Luceros' other income. The taxpayer petitioned the Tax Court for review, arguing that they had materially participated in the rental activities.
Lesson: What does not count for Material Participation
By the time the case got to Tax Court, counsel for the IRS suggested that §280A applied. If so, that would render the NOD disallowance under §469 moot because there would be no loss deduction to disallow. Accepting the taxpayers’ testimony on their amount of personal use, the Tax Court easily found that they fell within the §280A(d)(1) de minimis exception. Sure, they used the property for personal use for about a week. But that was pretty far below the amount of personal use that would trigger application of §280A.
The lesson here is about material participation. The taxpayers needed to get over the 500 hours threshold because they used a property management company and they were unable to show that they spent more time than any individual property management employee. So they really needed to show more than 500 hours.
Their failure teaches several points about material participation.
First, have contemporaneous records! Here, Judge Pugh was skeptical of the records created by the taxpayer for litigation purposes.
Second, do not count activities that are the same as what one would do as an investor. So while Mr. Lucero wanted to count the hours spent jawing with the property management company, preparing tax returns and paying bills, Judge Pugh said those did not count, citing to Treas. Reg. 1.469-5T(f)(2).
Third, do not count time driving to the rental. Judge Pugh likens it to a long commute. Here Judge Pugh cites to some travel-away-from-home case law, including the classic Flowers v. Commissioner v. Flowers, 326 U.S. 465 (1946). If you are scratching your head on that one, I’ve got more for you in the comment.
Fourth, police your records for exaggeration! Here, the taxpayers’ log they prepared for litigation contained obvious errors. Judge Pugh writes:
"Mr. Lucero’s log reported hours for tasks that appear excessive in relation to the task described, such as spending two hours shopping for coffee filters at Bed Bath & Beyond, and included time shopping both for the Sea Ranch property and for personal items, such as one hour shopping at Gualala Supermarket for 2 items for the Sea Ranch property (garbage bags and facial tissue) and more than 20 personal grocery items." Op. at 12-13.
Because these defects “permeated” the records offered to the Tax Court, Judge Pugh exercised her discretion to throw out the entire set of records as unreliable ex-post “ballpark guesstimates.” Op. at 13.
The one part of this opinion that I had a hard time following was the idea that the taxpayers could not count their travel time from Sacramento to Sea Ranch when the purpose of the trip was to manage, clean, inspect, or otherwise attend to the care of their rental property and was not for a personal purpose. The opinion is not clear what other sources of income the Luceros had, but I would guess their tax home was Sacramento. If so, then the reason for their travel away from home was in pursuit of an income-producing activity because there is no indication in the opinion that the activity was not engaged in for profit, which would mean that 183 hobby loss rules would apply to totally nuke the losses. If the activity was for profit, then the travel would not seem to be a personal commute. This, of course, would make the costs associated with the travel deductible.
It may be what Judge Pugh is driving at (pun intended) is that even if the costs of travel might count as expenses associated with the rental activity, the travel time does not count toward material participation time engaged in the activity because the time might well be spent listening to podcasts or engaged in conversation or doing something else that is not related to the activity. If it took 4 hours each way and the taxpayers made eight working trips to Sea Ranch, that would be 64 hours in the year towards material participation, if you allowed that time to count. And if they took the scenic route. ...
As usual, I welcome comments on that thought.
Coda 1: It appears that Mr. and Ms. Lucero still rent out their property, at least if this rental cabin called “Lucero” is theirs. If it is, go rent it as part of your U.S. tax tour vacation! The history of the Sea Ranch community was part of this exhibit at the San Francisco Museum of Modern Art.
Coda 2: Even if Mr. and Ms. Lucero materially participated, I note that they appear to be running yearly losses on the rental. Those might well trigger the §183 restrictions on deductions of expenses in excess of rental income. I would have thought that a better backup position for the IRS here than §280A, given the likely de minimis personal use. But, as usual, I do not know what else was going on in the case.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return every Monday for a new Lesson From The Tax Court.