Small Business Taxes & ManagementTM--Copyright 2015, A/N Group, Inc.
Many entrepreneurs, rental property owners, etc. engage in more than one activity. Not infrequently, the activities are bundled into a single entity. It may make sense from a business standpoint, but the IRS often challenges combinations when one turns and profit and the other produces a loss, or if one is a rental activity and the other a business. The latter was the situation in the case below.
In 1976, the taxpayer and his wife purchased 140 acres of farmland in rural Minnesota consisting of three contiguous parcels of tillable land and pasture land and an eighty-year-old farmhouse in need of substantial repair and renovation. In the years following, the taxpayers at times farmed the tillable and pasture land themselves but regularly rented the farmland to neighboring farmers for cash rent. On their income tax returns for 2005, 2006, and 2007, they deducted, as ordinary and necessary business expenses, substantial expenses that related solely to the farmhouse and surrounding outbuildings (e.g., insurance, repairs, supplies, utilities), in addition to their ordinary and necessary expenses related to the leased farmland. The IRS issued notices of deficiency that explained in relevant part, "Since the farm land is the only part of the property that is leased and income derived, you cannot deduct the expenses of owning the home on the farm."
The Tax Court denied their petition, disallowing $42,694 in claimed deductions because the taxpayers failed to prove that the farmhouse expenses were tied to a real estate property rental business for purposes of Sec. 162, or related to "property held for the production of income" within the meaning of Sec. 212. The taxpayers appealed to the U.S Court of Appeals.
The parties stipulated that all reported farm-related income was cash rent paid by neighboring farmers who leased the pasture and crop lands during the tax years in question. The taxpayers reported "Land Farm Rental" losses of $19,214 in 2005, $15,811 in 2006, and $7,649 in 2007. The IRS disallowed expenses of $20,523 in 2005, $14,336 in 2006, and $7,835 in 2007 because they related solely to the farmhouse. The question on appeal is whether farmhouse-related expense deductions should have been disallowed.
The taxpayers purchased the three contiguous 140-acre parcels together for $75,000 in 1975. They have never attempted to sell the land or the house; they estimate the entire farm is now worth $375,000. The taxpayer did not estimate the value of the farmhouse alone, but he did testify that it would be possible to sell the farmhouse separately from the land, by parceling off about ten acres with the house. They now reside in the farmhouse but lived in a separate suburban Minneapolis residence from the time they bought the farm until 2010.
The taxpayer testified that he was unable to rent the farmhouse to neighboring farmers who leased the crop and pasture land, so he sought cash renters by placing ads in newspapers, putting up notices in local stores, and telling various people in the area that the house was for rent. However, the taxpayers never found any renter who would pay in cash. Instead, they "rented" to persons who performed services on the property. From approximately 1976 to 1979, first the former owners of the farm and then a local couple lived in the farmhouse, performing services such as carpentry in lieu of cash rent. From approximately 1980 through the years at issue, the farmhouse was at times vacant and at times occupied by the taxpayers' relatives, who performed services including repairs and maintenance on the house. The taxpayers did not present records valuing these services. During this time, the taxpayer occasionally used the farmhouse as a place to change clothes or stay overnight when he was doing work on the farm, kept tools and supplies in the farmhouse and outbuildings, and always had access to the farmhouse.
The Code allows taxpayers deductions for their ordinary and necessary business expenses, Sec. 162, and for expenses incurred for the production of income, Sec. 212. Deductibility depends on whether the activity was carried on for income or profit. A taxpayer "need not have a reasonable expectation of a profit but must have a good faith intention of making a profit or of producing income." In deciding whether the taxpayer lacked a genuine profit motive, the Tax Court "is not conclusively bound by the taxpayer's stated intention."
The taxpayers argued to the Tax Court that their farmhouse-related expenses in 2005-2007 were deductible under Sec. 162 or, alternatively, Sec. 212. The Tax Court determined that they "failed to prove the deductibility of [the farmhouse] expenses under Section 162 because they have not proved that these expenses were tied to a real estate property rental business." The Tax Court further found the farmhouse expenses were not deductible under Sec. 212 because the taxpayers had not proved that they held the farmhouse for the production of rental income. The court noted that they "do not contend that they tried to sell the farmhouse or that they held it for possible appreciation in value."
On appeal, the taxpayers first contended the Tax Court erred in disallowing Sec. 162 deductions because they operated the farmhouse as a real estate rental business in the years 2005-2007. They urge two alternative Sec. 162 theories. First, they argue the evidence shows the farmhouse was a stand-alone rental business because they made ongoing efforts through local advertising to make a profit by finding persons who would pay cash rent for the farmhouse, despite the difficulty of renting a farmhouse in rural Minnesota. They correctly note that lack of past success and the doubtfulness of future success are not fatal to a claim of genuine profit motive.
During the years in question, the farmhouse was either vacant or occupied by relatives who lived there rent-free. The taxpayers stayed at the farmhouse from time to time and stored carpentry tools and supplies used to repair and remodel the farmhouse. The husband testified that the relatives provided repair and other services in lieu of cash rent. But the taxpayers kept no detailed record of these "barter exchanges," did not report rental income equal to the value of these services, and made no showing "that the value of these services in any way approximated the fair rental value of the property." As the Tax Court noted, evidence the taxpayers made no changes in their efforts to rent the property, despite thirty unsuccessful years, undermined their assertion that they sought to profit by renting the property. The lack of evidence of a rental property business strategy, and evidence they allowed relatives to live in the house rent-free, supported a finding that the taxpayers held the property as an alternative residence for the personal use of their extended family. On this bare bones record, the Tax Court did not clearly err in finding that they lacked a profit motive for the alleged farmhouse rental business.
Alternatively, the taxpayers argued the Tax Court erred in rejecting their contention that the entire farm was "a single rental business involving multiple related undertakings" and therefore all expenses of that single business, including the farmhouse expenses, were deductible. This contention was governed by Treas. Reg. Sec. 1.183-1(d)(1), which provides: Where the taxpayer is engaged in several undertakings, each of these may be a separate activity, or several undertakings may constitute one activity. In ascertaining the activity or activities of the taxpayer, all the facts and circumstances of the case must be taken into account. Generally, the IRS will accept the characterization by the taxpayer of several undertakings either as a single activity or as separate activities. The taxpayer's characterization will not be accepted, however, when it appears that his characterization is artificial and cannot be reasonably supported under the facts and circumstances of the case.
The taxpayers argued their characterization of the farm as one activity with "three interrelated income-generating parts" was not an "artificial" characterization; they purchased the farmhouse and farmland together as an investment and "viewed both the land and the farmhouse as opportunities to make the farm more profitable."
Whether leasing the farm land and attempting to rent the farm house were activities to be considered separately or together "was a question of fact for resolution by the Tax Court." The Tax Court found that the taxpayers "differentiated the farmland from the farmhouse and rented out the farmland separately," and "did not abandon all personal use of the farmhouse." The Appeals Court could find no clear error. Throughout their ownership of the property, the taxpayers "rented" the farmhouse separately from the farmland, retaining access to and control over the farmhouse for personal purposes, including staying overnight or changing clothes there themselves. They offered no evidence they ever tried to rent or lease the farmhouse and farmland together. The taxpayer testified the farmhouse could be parceled off and sold separately from the crop and pasture land. The Appeals Court said the Tax Court did not clearly err in finding that the taxpayers treated the farmhouse separately from the leased farmland, which was admittedly a business activity, and therefore expenses related solely to the farmhouse could not be deducted as ordinary and necessary expenses of the leased farmland activity.
The taxpayers argued the farmhouse was property held for the production of income, making farmhouse expenses deductible under Sec. 212. The term "income" for purposes of Sec. 212 includes income the taxpayer "may realize in subsequent taxable years; and applies as well to gains from the disposition of property." However, "no deductions are allowable for expenses incurred in connection with activities which are not engaged in for profit." The regulations identify nine-factors to consider in determining whether an activity is engaged in for profit. The Tax Court found that the taxpayers did not prove the farmhouse was held for the production of income during the tax years in question because they "did nothing to generate revenue during the years in issue and had no credible plan for operating it profitably in the future. There was no affirmative act (renting or holding for appreciation in value) to demonstrate that the property was held for the production of income." This finding, too, was not clearly erroneous. Without question, the taxpayers' expenditures for substantial repair and improvement of the farmhouse over many years, including the tax years in question, increased the value of that property. But they failed to prove that they were holding and improving the property to profit from its rental or its appreciation, as opposed to improving it for personal use. The reasonableness of this alternative personal-use explanation for the expenditures in 2005-2007 was rather dramatically confirmed when they sold their home in suburban Minneapolis and moved into the farmhouse in 2010.
Donald B. and Arvila Meinhardt U.S. Court of Appeals, Eighth Circuit, Affirming the Tax Court, T.C. Memo. 2013-85.
The first issue here was the IRS claiming the taxpayer was engaged in two separate activities--the rental of farmland which was a business--and the farmhouse which would be a rental activity. The IRS successfully argued that the two could not be combined. That might not have been the result if, for example, the buildings consisted only of barns, storage sheds, etc., that were rented with the farmland. The Court noted that generally the IRS will accept several undertakings either as a single activity or as separate activities. But that's not the case if the characterization appears artificial or can't be reasonably supported.
In this case the IRS challenged the deductions for the farmhouse because it was neither a business nor held for the production of income. In order to be held for the production of income a taxpayer must either be in the process of renting the property (or other income producing activity such as the cutting of timber) or holding it for appreciation. In either case, the IRS could apply the hobby loss rules of Sec. 183. For approximately 24 of the 31 years the farmhouse was available for rent, the taxpayer had relatives living in the farmhouse rent free. Allowing individuals to live in the house rent free connotes personal use. And, except for listing the property for rent, they apparently had no credible plan for operating it profitably in the future.
In different circumstances the taxpayer may have fared better if he had rented the property for a fair rental and paid the renters for the work performed instead of bartering for the work. Unfortunately, the very limited rental activity coupled with personal use of the premises was unlikely to convince a court, even if barter had not been involved. A change in the taxpayer's business approach to the property when it was unable to rent the property may have salvaged the deductions.
Keep in mind that not all rentals are the same. The rental of equipment (vehicles, office equipment, etc.) is different from the rental of an office building, home, retail space, etc. The rental of raw land is also different. And short-term rentals of a home, condo, etc. fall into another category. Finally, special rules apply to the rental of real property to a business if you have an interest in both the property and the business.
The situation described above is far from unique. While the real estate market has improved, many areas remain stagnant. That may be particularly true for a property in a rural area that's not up-to-date, has issues such as a leaky roof, poor insulation, etc. If you have such a property, you may be able to salvage your deductions by showing a plan to rent or sell, taking action, changing strategies if the current approach isn't working, and consulting professionals such as realtors. Talk to your tax advisor before the situation gets out of hand.
Copyright 2015 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 01/14/15